Good day, everyone. Welcome to the Palo Alto Networks 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 Niederman, 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 Networks 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.paloaltonetworks.com. With me on today’s call are Nikesh Arora, our Chairman and Chief Executive Officer; Kathy Bonanno, our Chief Financial Officer; and Lee Klarich, 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’d like a copy of the release, you can access it online on our website. 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 marketing opportunity for our products and subscriptions, benefits and timing of new products and subscription offerings, and trends in 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 our views in the future, and we undertake no obligation to update these statements after this call. For a more detailed description of factors that could cause actual results to differ, please refer to our annual 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 8-K. Also, please note that certain financial measures we use on this call are expressed on a non-GAAP basis and have been adjusted to exclude certain charges. For historical periods, we have provided reconciliations of these non-GAAP financial measures to GAAP financial measures in the supplemental financial information that can be found in the Investors section of our website located at investors.paloaltonetworks.com. And finally, once we have completed our formal remarks, we will be posting them to our Investor 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 spoke with our President, Amit Singh earlier today. He just finished a two-day review of our sales teams around the world. He was more excited than I've ever seen him since he started Palo Alto Networks. He was enthusiastic that we are having more strategic conversations than ever around the world. Our strategy around cloud security, securing the stack and adding capability to our firewalls is resonating with customers. We are launching more integrated capability than ever before, and our customers are responding well to our efforts. Amid 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 by becoming more relevant to our customers and building a second and third leg to our security business, which is the hardest thing to do. 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 towards the Next-Generation Security. Of course, we 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 the 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 are 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 these people is now in place. We've hired Andy Elder who joined us from Riverbed and Alan Boswell who joined us from Cisco, who will be leading this speedboat. Secondly, we recently launched SD-WAN across our entire portfolio. When combined with Prisma Access, we believe this is a great SASE solution. We're still in the early stages, but we have closed some deals and are seeing heightened interest from our customers and positive feedback on the vision and simplicity of the 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 quarter. So let me revisit that in terms of what it means to our outlook going forward on product and its impact on Palo Alto Networks. We expect product growth to improve in the second half of fiscal 2020 and turn positive in fiscal Q4. However, products will still be below our internal expectations. We expect that product will return to market growth next year in fiscal 2021. We have put cost-containment measures into place to match our investment trajectory with our profitability expectations. 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 in double-digit growth this year. The management team and I have revisited our three-year guidance that we gave at Analyst Day. Only two quarters into that guidance upon deep inspection, we still have confidence in our long-term outlook for fiscal 2022. Now that we've talked about the product issue and the impact on financials, let's talk about what's working. I have met and seen over 100 customers this quarter. Our strategy is resonating. Organizations everywhere are undergoing a profound digital transformation, reshaping the way they operate, innovate, and connect with the people they serve. These transformations are helping drive the need for Prisma and Cortex. I'd like to share a few key details from the quarter. In fiscal Q2, another customer illustrates the power of our comprehensive approach to security, including a large U.S. retailer who expanded the Palo Alto Networks footprint this quarter with an eight-figure deal spanning each of our three pillars including Prisma Cloud, Prisma Access, SaaS Cortex, and our next-generation Firewall. This is one of our largest deals in recent times and a true cost platform with Prisma, Cortex, and Firewall. The multinational travel management company expanded with next-generation Firewalls and Prisma Access following the purchase of Demisto last fiscal quarter. It's a great example of how one of our next-generation security services opened the door with a major account for future 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 employees and also transition away from MPLS. Our solution not only provides significant flexibility and increased visibility, but our customers also drive substantial savings compared to prior architectures. We have a deal with a large German automotive company who purchased Prisma Cloud Compute, formerly known as Prisma. Prisma will be a critical pillar of the customer's move to a 100% cloud-first architecture and shift to a less security model. 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 2020, 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, this time their firewall. In December, we launched the SD-WAN for our next-generation firewalls. Customers are currently getting this offering and feedback is positive as they appreciate our vision and 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 can seamlessly leverage the capability to deploy container security. Following its launch, we have seen 10% of our customers take up both modules. This is exciting because we are hard at work to develop and deploy four modules over the course of this year, including the integration of Aporeto. Turning to our marketing efforts, if you will be attending RSA, you will likely notice a fresh look and feel of the new Palo Alto Networks branding. Additionally, we have launched a stand-alone brand for our firewall business, Strata. Over 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 firewall needed its own brand. All three brands were part of Palo Alto Networks, which also supports a new updated logo. On the people front, we are 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 announce our perfect score on the Human Rights Campaign Foundation's 2020 Corporate Equality Index and the designation of a 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 transaction or ASR that we announced earlier today in our earnings press release. The proposed ASR amounts to $1 billion and is expected to occur in our fiscal third quarter, representing the capital allocation strategy that we believe returns value to shareholders while still allowing us sufficient flexibility to achieve our goals. The proposed ASR is in addition to the $1 billion repurchase authorization that we announced in February 2019. As of today, approximately $800 million remain 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's 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 in Prisma, a new frontier in AI and ML and Cortex with our customers' need for security automation. Last, but definitely not the least, Firewall technology will continue to support our customers in their data centers or in the cloud and we will be there beside them. With that, I'll turn the call over to Kathy.

Thank you, Nikesh. Before I start, I'd like to note that except for revenue and billings figures, all financial figures are non-GAAP 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 continue 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%. Q2 product revenue of $246.5 million declined 9% compared to the prior year. Q2 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 2500 new customers in the quarter, we continued 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 $0.75 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, 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 million 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 Q3 2020 non-GAAP EPS to be in the range of $0.96 to $0.98 using approximately 99.5 million to 101.5 million shares. For the full fiscal year, we expect revenue to be in the range of $3.350 billion to $3.390 billion, representing year-over-year growth of 16% to 17%. We expect billings to be in the range of $4.075 billion to $4.125 billion, representing growth of 17% to 18% year-over-year. Next-Gen Security billings are expected to be in the range of $810 million to $820 million, representing year-over-year growth of 79% to 82%. We expect fiscal 2020 non-GAAP EPS to be in the range of $4.55 to $4.65 using approximately 99 million 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 2020 non-GAAP effective tax rate to remain at 22%. CapEx in Q3 will be approximately $85 million 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 million 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 settlements. With that, I'd like to open the call for questions. Operator, please poll for questions.

Thank you. We'll hear first today from Hamza Fodderwala with Morgan Stanley.

This is Hamza Fodderwala in for Keith Weiss. Thank you for taking my questions. Just a couple of ones for 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 are very few examples in enterprise security of companies building a second or third product line to the first product line. We spent a lot of effort with the team trying to figure out how we could build where the opportunities were related to cloud, related to automation, and machine learning. We made some significant investments both in terms of acquisitions and resources in driving Prisma and Cortex. That change 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. The problem was, because they were focused on this, they didn't go knock on enough doors to create Firewall demand. As you know, there's a cycle from demand to closure which has its own motion that takes time. We discovered that much later in the year, and while we're delighted with the success of Prisma and Cortex in Q4, we realized that we had been systematically rolling the opportunity to have a large pipeline going into Q1, which is why you saw our Q1 results. We were optimistic that we would be able to accelerate that effort to close deals sooner. Unfortunately, it was hard to fight that tape. There is a cycle, there is a motion, and our customers are used to it. Hence, we had to revise our product efforts. In terms of what's going on in the market, yes, SD-WAN is a trend. There are other companies out there who are doing well with SD-WAN. We have SD-WAN partners. Every time we go sell Prisma Access as part of our SaaS-based solution, either we deploy our own SD-WAN or customers choose other SD-WAN packages. Definitely, SD-WAN is a trend. We think as people go to the cloud, as network architectures change, and/MPLS starts to be pulled off, 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 a focus, and we're excited about the progress we've made since December in terms of getting customer interest in our solution. Other than that, honestly I think this is an execution issue. I don't see that the market is changing.

Just to ask 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 about 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.

Yes. 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 the EDR category where some of the newest endpoint vendors have migrated. We keep adding more data sources into our injection capability. XDR is doing well. Our primary customers have come mostly from Palo Alto customers without our firewall and some new customers who want our endpoint capabilities from the XDR perspective. That business is doing well. What we announced this morning was the Cortex XSOAR, which is the next evolution of what was Demisto. In the past, we sold Demisto to our customers, and the constant feedback we got was it would be amazing to track management to be part of this capability rather than have to stitch it on top of our capabilities to automate and apply playbooks. Our team has merged management with that capability, and hence we defined the XSOAR. Industry analysts have been calling for this, and we are first in launching that capability. Purely from a mechanical perspective, every customer who is a customer of Demisto should want an upgrade to this capability. Additionally, it should open up a larger market for us within the Demisto Intel market, which we think is probably the same size as the SOAR market. We are very excited about it.

We'll hear next from Walter Pritchard with Citi.

Thanks, Nikesh. I have a question about cash flow related to sales incentives and the customer demand perspective. While we acknowledge that Firewall demand isn't as strong as it was two or three years ago, we hear that customer spending on Firewalls is either flat or slightly increasing. Can you provide insight into how this relates to your customer base, especially with Firewall revenue declining for two consecutive quarters? Are customers delaying their purchases or planning to hold off for the future? I'm interested in understanding this from the buyer's viewpoint, considering the initiatives you've implemented on the sales incentive side regarding supply.

Thank you, Walter. That's a great question. From a buyer's perspective, each customer is at a different stage in their infrastructure journey, whether they are expanding data centers, transitioning to the cloud, or creating a hybrid cloud and data center setup. As I mentioned earlier, there is a clear demand for SD-WAN solutions. Buyers are seeking SD-WAN options that include security features. Sometimes this means a hardware solution, while other times it involves software. We can provide both types of SD-WAN capabilities. Our offerings include a hardware solution that supports SD-WAN as well as Prisma Access, which allows SD-WAN to be deployed in the cloud. There is certainly movement in this area. Customers are rethinking their network architectures and evolving their strategies. Larger data center customers are also going through their refresh cycles. Overall, we haven't noticed any major shifts in market dynamics that would indicate a change. While there might be slight differences between cloud and hardware solutions, we don't see any significant changes at this moment.

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, can you help us understand what level of firewall or product sales you were anticipating there? And any color you can provide around sensitivity to that overall growth number given the performance you've seen here on the product side in the near term would be great.

Yes, Walter. Thanks for that question. We did not guide explicitly on products. But I think for the most part, analysts were projecting less growth than we have seen historically on the product line, which was appropriate and reflected in our guidance. So, that change is being managed, 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. We definitely think as Nikesh mentioned that we believe 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.

From JPMorgan, we'll move next to Sterling Auty.

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

I'm going to let Kathy answer the parity question but I won't tell you from our product revenue forecast, we've looked at the pipeline and looked at the early indicators we think that in Q3 it is going to continue to be tough but we should be able to get to positive growth by Q4. Our teams are hard at work to make sure that we reverse these trends and that next year we're back to that 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 you look at our firewall forecast, you should be able to derive that answer. I'm going to let Kathy answer that question in case.

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

Great, great. Thanks. 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?

No again, I think on a geographic basis, there is no trend. 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, thinking about changing network architectures. They generally lagged some of the U.S. companies in that context. So we're seeing traction in different parts of the world to varying degrees. So no, I think the market is only going to get bigger internationally. As Kathy said, we're all watching the coronavirus, and I think you all look at the market today. I think whatever impact happens because that will happen across the industry will not be specific to any one company, but we have some – 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. Appreciate the color.

We'll move next to Karl Keirstead 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 Q3 would – there'd still be a decline but less than negative nine? So better than negative nine 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 the floor let's say?

Yes, that's correct Karl.

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

Not just one or two. We both expect that.

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

Yes. The details of the settlement are confidential, so we won't be describing a lot in our Q 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 Turits.

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

Alright. 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 requiring and talking about SD-WAN. I remember that customers have a choice of taking the best SD-WAN in the market which are independent players or taking that as part of an integrated firewall solution. We've seen customers consume either, depending on the complexity of their needs for SD-WAN. If they are going to deploy it across 10,000 sites or 8,000 sites, they will likely get a specialist SD-WAN vendor, because they have a whole bunch of tools to deploy, configure, and set up. This is a much more complex process than what is available in the market. Sometimes customers want to do a simpler architecture and just use what's available within their firewalls. We're seeing a market for that too and that is the market we will be able to address with the evolution of our firewall capability and the maximum capability we have with the SD-WAN that we 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 Palo Alto firewall, so I'm going to go elsewhere. But clearly, other companies are doing well. Now, that may be some of the market segment issue, but I haven't seen that much in the large enterprise space. In terms of what it does to the network transformation market, remember, when I came to Palo Alto Networks, we had a product called GPCS which we deployed a lot of resources against. We worked really hard over the last 18 months. Lee and his team did a great job launching Prisma Access and delivering it. We've had this product in the market for almost only three quarters. In that three-quarter time frame, we have made huge inroads with the very large customers that deployed large deals. I highlighted some of the deals earlier in my prepared remarks, and that was a large Prisma Access deal. In a market where we were not perceived strongly, we've made more significant inroads there, and we need to continue to work hard in the Southeast space because we believe that we have one of the most comprehensive solutions there. Was there a third part to your question?

Yes. That was off from the cash. My follow-up is did you make any additional incremental changes to the incentive structures as you saw that things are taking longer this quarter?

Look, we have a very capable, responsible, and intelligent sales team out there. 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. We 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 honestly takes time. The Firewall cycle has a time element to it. I call it less judgment in the last quarter when we look at the deal pipeline. The expectations we had for Q1 were optimistic, and we've got to adjust to the actual progression of deal closures. We're just trying to make sure that we are no longer setting unrealistic expectations for deal closes in our pipeline and giving a reasonable forecast to you and setting the right expectations for our team.

Okay. Thanks, Nikesh.

We'll move next to Brent Thill with Jefferies.

Hi. This is Howard on for Brent. Thanks for taking the questions. Nikesh in your prepared remarks you mentioned you had gathered feedback from about 100 key customers. Could you share any additional details regarding 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?

Yes, thank you for the question. Look, I'll tell you a funny story. When I did the customer tour when I started at Palo Alto Networks, I received a lot of curiosity meetings because people wanted to know who's this new guy who's come into cybersecurity, wanting to talk to me. I went there and talked about firewalls and told them about all of our subscriptions. Many were polite and listened to me nicely but bowed their heads. They had been buying firewalls for 15 years. It might have been new and exciting for me, but it wasn't for them. What changed in the last 18 months is that we talk about cloud transformation and how the cloud transformation must be secured with Prisma Access and Prisma Cloud. Customers are realizing their stacks are getting too much data. In the expense of that data, they want to be more secure so now we are having real conversations where they want to talk about this transformation, and slowly and steadily it's emerging that we're one of the few companies who have those products and are committing to developing them with our customers than anybody else in the market. I would challenge the industry to show us who else is out there talking about these topics with our customers. The conversations have really been engaging. They're meaningful. We are seeing a lot of conversation in network transformation. We are seeing many conversations with customers who want to be in multiple clouds. A year ago, they were mostly focused on a single cloud. A year later they are dealing with instances of different cloud infrastructures being used by different parts of the organization. They now want a multi-cloud security solution. The conversations are changing in terms of what people are discussing. In terms of demand, I don't think you're going to see a subscription model for on-prem firewalls anytime soon because there are many players in the space and customers have a way of buying these things and capitalizing them. If someone wants it, we can construct a financial solution for them that allows them to buy that way. Honestly, we're not seeing demand for financial creativity to buy firewalls. There will be some conversations about how architectures need to be fungible if I have a data center and a cloud install. Our teams are working hard to understand that need and see if we need to make any forays in that direction.

Thank you, Nikesh, for the insightful information. I have a follow-up question for Kathy. It appears that subscription billings were quite strong, largely due to Cortex XDR. If the product aligned with expectations, given that the overall billings figure was at the high end of your guidance and despite the reduced full-year revenue guidance, which was only down by $20 million to $30 million, would total billings have warranted an increase?

Well, I think this is 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 opening 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. So delivering them on Cortex and Prisma more aggressively than we expected is creating a product mix. So, we're making it hold, which is interesting and creates a short-term financial impact, but this is phenomenal news for the long term. We have deferred revenues rising better than it has in the past. So, I will let Kathy add more color to that.

Yes. We've obviously been really thrilled with the strong subscription performance, not just NGS, but also our cash subscriptions are growing nicely. We've introduced some new subscriptions DNS and SDN, which are very new. We've also launched a platinum support product as well. 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 feel very good about all of those numbers. The product decline is certainly the driver of all of the changes to our revenue and billings guidance.

Okay. Thanks a lot.

Moving on to Nehal Chokshi with Maxim Group.

Yes, thank you. I'd like to inquire about the timing of the accelerated share repurchase. Additionally, what is the reasoning behind the decision to only repurchase between $200 million and $1 billion thus far?

Yes, thank you for the question. We have a plan in place that allows us to repurchase stock using part of the $1 billion authorization at specific levels. Considering the strength of our billings, the company's growth trajectory, and our confidence in the management team, we recognized the product execution challenges we faced. Despite this, we believe in the long-term potential of the company. Therefore, we feel that the best way to support our shareholders is to return capital by buying back shares, as we find them very attractive at the current levels.

And it will take place in the third quarter.

Looking at that $3.5 billion of cash on the balance sheet, we've outlined our M&A strategy, which says we're going to do tuck-ins to our product strategy rather than trying to do any big M&A. So, from that perspective, we felt given that we generate close to $1 billion of free cash flow every year, that gives us enough financial flexibility to be able to do this at this point in time.

We'll hear next from Shaul Eyal with Oppenheimer.

Thank you for taking my question. This is Yi Lee for Shaul. We have two quick questions. First one for Nikesh. I think you talked about in the prepared remarks that certain key indicators tracking expecting positively on the firewall side. Nikesh, can you help us?

We're having a hard time hearing you. Sorry, can you speak up? We're having a hard time hearing you.

Thank you for taking my question. This is Yi Lee for Shaul. Nikesh, in your prepared remarks, you mentioned that there are some key metrics tracking positively on the firewall side. Can you elaborate on what metrics you are monitoring?

Yes. Look, as in any good sales organization, you have to look at your deals, you have to look at pipeline, you have to look at how many customers are evaluating your firewalls versus how many customers are up for refresh. We track all those metrics, and we're seeing positive indications of those metrics that our pipeline is robust. We are optimistic in this quarter that we have been able to close a lot more deals sooner than normal, but we think they are going to take a normal time. We believe we will see those indicators trend up, providing confidence about our Q3 and Q4 revival expectations from our product business.

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

Yes. 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 feedback now U.S. and EMEA as well as APAC. If we could get some color on the year-over-year growth rate. And maybe comment a little bit on the distribution channels going forward?

Yes. So our growth by theater was 15% in the Americas, EMEA's growth was 12%, and APAC was 20%.

Thanks, Kathy and Nikesh.

Thank you.

And from Guggenheim Partners, we'll move next to Taz Koujalgi.

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. So what's the offset given that you're guiding down product revenues by $90 million? And you're not even raising your next-gen guidance. So what is the offset for billings versus the decline in product revenues?

Yes. As I mentioned in the response to the last question, we are seeing strong subscription growth. Not just in our NGS subscriptions, but also our cash subscriptions are growing nicely. We've introduced some new subscriptions like DNS and SDN which are very new. In addition, we've launched 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. The product decline is certainly the driver of all of the changes to our revenue and billings guidance.

Got it. And then one second question. Just to clarify, you mentioned that product revenues would be positive in Q4, right? Because if I do the math on your full-year revenue guide, then assume typical seasonality on your support and subscription revenues, it still leads to negative product growth for obviously Q3 and also Q4. So can you just clarify 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.

Got it. Thanks, Kathy.

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 Palo Alto had trouble establishing and then hitting targets. So while on the subscription side things have gone quite well, the performance of products has been very different. So you're guiding to a lesser decline if you will in Q3 and then product growth in Q4. But what's the process that you think that you've either improved 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 rates so to speak on the targets that you established? And 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-digit revenue growth and you are down 9%. So it's a 20% spread on your product growth rates. It's just hard to believe that there's not competitive activities causing meaningful share loss. So I just want the corollary question on what gives you the confidence that you're not actually losing share and this is more internal than external? And that's it for me. Thank you.

Thank you for your question. I want to reiterate some points I made earlier. Last year, we made our forecast and were pleased with the growth in Next-Generation Security and anticipated that product growth would continue. Most of that came to fruition. However, in Q4, we experienced a slowdown in product performance. The growth we saw in Next-Generation Security was affected as our teams focused on earning commissions for themselves. When we review the numbers, as analysts have noted, we are still achieving significant billings and leading growth in cybersecurity. No other company of our size is delivering the numbers we are. While I understand your concerns about the product aspect, we share those concerns. Regarding the competitive landscape, I think it's misleading to compare revenue spreads, as Fortinet operates in different segments than we do. We've analyzed the whole market and evaluate each deal, understanding who our competitors are. Therefore, we gauge our competitive data on a customer-by-customer basis, assessing who we are up against and in what context. To summarize, we remain confident in our position.

Nikesh. Jump in though but in terms of the forecast the last two product forecasts. Have you put a higher, a bit more conservatism you think as we look out the next two quarters?

Yes, I just want to be sure that you understand we haven't guided on product growth. I think you could look at our history of when we've missed, you would really not find many quarters where we missed. And we do pretty well compared to those companies, would be my guess.

Alright.

Okay. I would not seek 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 that was the big launch back in December last year. I'm just wondering if you could share any anecdotes on SD-WAN kind of early feedback? And I guess not to flog the dead horse on product stuff, but is that a contributing factor? Or just any color there would be great.

Yes, look, as I mentioned, there is a lot of interest out of the market from an SD-WAN perspective. Remember, there is a very large installed base of MPLS. As people are going down the cloud journey, they're looking at the fact that they don't need to bring all their traffic back home to their data center; they can send it from their branches, remote offices, and other data centers straight to the cloud. This is causing the SD-WAN conversation to happen. It's pretty standard now that people will replace that MPLS solution with Internet as well as SD-WAN, but they need security as well. So with that as a background, since Lee is here on the call, I feel like he has to earn his keep on the call. Lee, can you talk more about the SD-WAN market?

Sure, Nikesh. Happy to earn my keep. But 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 and 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 larger deals coming through as well. Perhaps even more exciting is that, while these additional 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 they really like our ability to combine this with Prisma Access in a more SASE kind of solution where we're providing both networking and security from the cloud and lighter weight branch deployments to connect to that cloud. That's the promise of SASE. We're getting a lot of very good feedback from customers about that being the future of these network transformations.

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

Yes. I actually separate those two things. Ransomware is generally a solvable problem. We have several 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 focused more on building Zero Trust architectures, designed around an increasingly mobile workforce, an increasing number of devices, locations, and devices, as well as increasing public and private cloud deployments, where customers' enterprise architectures are transforming. They are looking to move to an increasingly Zero Trust architecture, which then leads down the path of needing better segmentation to have the right enforcement points in the right parts of the network. We are very well suited for this because, in that architecture, it's not just about location devices; it's about being able to build context-oriented policy everywhere and consistently. We've been unique in having that ability for many years.

Great. Thank you very much.

And from Mizuho, we'll hear from Gregg 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 rate. I realize that you're taking 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?

I thought I had you by saying we're going to market growth or better because I didn't want to predict the firewall market. That's a very good question. Thank you. Look, the reason we're not expecting to grow faster than market from a share perspective is that we believe we will be taking share. We will be taking share in the software form factor. Every solution that can solve the problem that is sold by a box by some of our competitors will be sold by VM. We sold by container VM. We sold by Prisma Access delivered by a cloud solution. All these things do not classify as product revenue in the way we report. All these things end up in next-generation security. 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. Yes, we definitely expect to be taking market share from everybody else. We think that we'll be recommending software solutions to our customers with SD-WAN with VMs for the cloud and container VMs; they will depend on what customers want. However, it's not going to follow the product box. So yes, I believe I can sustain product growth at market levels, which means I have a lot of new 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 simply as a direct replacement of 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 from customers or from the channel on the recent appliance price increases? Thank you.

Yes, we observed a slight increase in our discount rates this quarter. Overall, considering the price increase on our products, we believe we are at least maintaining parity, if not slightly improving, with the recent price adjustments.

Okay. Thank you.

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

Great. Thanks for marking 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 in the product side? And then, what do you see as the key levers to drive that component of the business going forward? Thanks.

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

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. Yes. And we've seen that historically. Yes, for sure.

Okay. Thank you.

Yes, you bet.

Moving on to the next question. 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 and 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.