Good day and welcome to the Palo Alto Networks Fiscal Second Quarter 2018 Earnings Conference Call. Today’s conference is being recorded. At this time, I would like to turn the conference over to Ms. Kelsey Turcotte, Vice President of Investor Relations. Please go ahead ma'am.

Good afternoon, and thank you for joining us on today’s conference call to discuss Palo Alto Networks' fiscal second quarter 2018 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 Mark McLaughlin, our Chairman and Chief Executive Officer; Kathy Bonanno, our Chief Financial Officer; and Mark Anderson, our President. This afternoon, we issued a press release announcing our results for the fiscal second quarter ended January 31, 2018. If you would 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 and full-year fiscal 2018, our competitive position and the demand and market opportunity for our products and subscriptions, benefits and timing of new products and subscription offerings, our ability to drive outside growth rates, expectations regarding the impact of the US Tax Cuts and Jobs Act and trends in certain financial results, operating metrics, mix shift and seasonality. 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, and 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 quarterly report on Form 10-Q, filed with the SEC on November 21, 2017 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. We’d also like to remind you that we will be participating in the Morgan Stanley Technology Media and Telecom Conference in San Francisco on Thursday March 1st and Raymond James 39th Annual Institutional Investors Conference in Orlando on Tuesday March 6. And finally, once we have completed our formal remarks, we will be posting them to our Investor Relations website under Quarterly Results. And with that, I’ll turn the call over to Mark.

Thank you, Kelsey. And thank you everyone for joining us this afternoon for our fiscal second quarter 2018 results. I am pleased to report that we delivered a strong second quarter. On a year-over-year basis, Q2 revenue is $542 million, up 28%. Billings were $675 million, up 20%. Non-GAAP operating margin was 20.5% and non-GAAP earnings per share was $0.97. In the quarter, we continued to see healthy security spending and strong demand for our next-generation security platform. With the addition of close to 3,000 new customers in the quarter, we are privileged to now serve approximately 48,000 customers around the world. In addition to robust new customer acquisition, we also continue to rapidly increase our wallet share and existing customers. Our top 25 customers, all of which made a purchase in this quarter spent a minimum of $25.6 million in lifetime value in Q2, 54% increase over the $16.6 million in Q2 of fiscal 2017. Specific examples of customer wins and competitive split displacements in the quarter included a Cisco replacement to secure the global network of one of Europe's largest manufacturing companies with more than 150 branch offices and factories, a legacy AV replacement and competitive win against multiple standalone next-gen end point providers in a US-based hospital system on tens of thousands of endpoints, a checkpoint replacement to secure 2,000 gas stations with our VM series and a deal with a global oil company, a seven-figure on-premise deal with the global retailer that started with us as an Amazon Marketplace customer, and an expansion deal with one of the world's largest insurance companies to implement GlobalProtect Cloud Service to secure hundreds of branch offices and tens of thousands of mobile users. We continue to see customers adopt and expand the uses of our platform at rapid rates.…

Thanks Mar. 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. I am very pleased with our second quarter execution, as we continue to add new customers at a rapid pace while also driving robust expansion business. We are seeing a high degree of interest across our platform which further extends our leadership position. With a consistent results of us growing faster than our competitors at scale. In addition to market leading growth, in Q2 we again expanded non-GAAP operating margin, delivered record non-GAAP EPS and generated strong cash flow. In Q2, total revenue grew 28% to a record $542.4 million. Looking at the geographic growth of Q2 revenue, the Americas grew 26%, EMEA grew 35% and APAC grew 33%. Q2 product revenue of $202.2 million grew 20% compared to the prior year. Sales of the new hardware which we launched in fiscal Q3, 2017 continued to perform well with both new and existing customers. Q2 SaaS based subscription revenue of $183.3 million increased 36%. The support revenue of $156.9 million increased 31%. In total, subscription and support revenue of $340.2 million increased 34% accounted for a 63% share of total revenues. Turning to billing, Q2, total billings of $674.6 million increased 20%. The dollar-weighted contract duration for new subscription and support billings in the quarter was approximately three years essentially flat compared to the prior year period. For the first half of fiscal 2018. Billings of $1.3 billion increased 18% year-over-year. Product billings were $387.2 million, up16% and accounted for 30% of total billings. Subscription billings were $492.6 million, up 24%. Support billings were $391.3 million, up 12%. Renewal rates for our SaaS subscription business are…

Thank you. And we'll take our first question from Andrew Nowinski with Piper Jaffray.

Hi, great. Thanks for a nice corner and thanks for taking the question. I guess I want to ask about Pan OS8.1. You talked about some of the new SSL encryption capabilities in that platform. Are your customers seeing an increase in encrypted traffic coming into the data centers? And are the new features that address this problem, a free upgrade for customers and/or could that potentially drive a refresh cycle?

Andy, it is Mark. Good question, yes, we're seeing across the board an increase in encrypted traffic, that's been the case for quite some time actually, it's not uncommon for us to see in a customer environment north of 35% - 40% of all traffic being encrypted these days just simply because the bad guys know that the legacy technology is not going to be able to decrypt it or if it can, it can't do it fast enough to have traffic continue to be, in essence of the real-time aspect it has to be. So we've been continuously trying to improve the capabilities there. Every release we've done has improved SSL decryption throughput. The release of the new hardware has about 20 times your performance which is fantastic and the 8.1 software also has capabilities in it as well to help with throughput and performance. As you know, I think for our operating system we don't charge extra for that, so those are features and functionality that go into the software just to make us better and better and better all the time. So we hopefully will continue to be sticky. And then the last point of the question as far as upgrades and refresh capabilities, yes, anything that has an opportunity for us to speak with customers about new use cases is a great opportunity as well for refresh and upgrade and expansion.

Okay, thanks and then maybe just as a quick follow-up. I see you launched another service as part of the application framework. Can you just give us an update on the progress the third parties have made regarding the development of applications that could start to contribute revenue to your framework?

Yes, sure. Just briefly the one we launched is called magnifier, and that came to us through the LightCyber acquisition last year. So we're super happy to see that go live. Basically, LightCyber has a fantastic behavior analytics capability. It formerly would be something that you would have to plug in as another piece of hardware, it’s somewhere in your environment. So we've taken the algorithm out and made it the application. So it's a SaaS application in the application framework, and that's the theory behind the application framework in a lot of cases. Third party-wise working about 30 companies right now to get their applications live and we expect that to happen in the coming months here. We're excited about that and just stay tuned as we progress through there. In the Spring, you’ll hear more about that.

Our four our next question we will go to Michael Turits with Raymond James.

Hey, guys. Really strong quarter and again a really strong quarter on product. Last quarter you talked about some of the things that really drove hardware and product. Can you drill down a little bit on that this quarter and especially the extent to which some of that may be coming from a product refresh cycle?

Yes, Michael, yes, we had a good quarter across the board on the entire platform, it is really -- we’re really pleased to see the market coming to the platform for all three of the evolutions that we had driven and obviously product is performing very well indeed. So we are super happy to see that. As we said coming into the year that on the refresh side that's a net positive for the company, and we expect that to continue to be the case, but it wouldn't be the primary driver for hardware in the year, and that is still the case. So we're seeing the over performance being driven from new customer acquisition, you can see it's really high in expansion business as well. Refresh is going very well lately, but it’s still not the major driver for the business. So we think that's something that is in front of us which will be great.

And just a follow up and maybe just more drill down, I think the service provider was really strong, high end chassis were strong last quarter, did that continue and was that a material part of the upside this time?

Yes. Our service provider business is doing very well for us. Last quarter, we had said that on the hardware side we had seen some over performance on hardware dollars associated specifically with what's called NBC cards, those are slot cards you put into the chassis and we saw more than usual. This quarter was nothing unique in that regard. So back to kind of normal run rates we see along that. So that's what we talked about last quarter for some of the hardware over performance, but the service provider business in general is doing well for us and continues to grow. We expect that to keep going as we said every time we do a release whether it’s hardware or software, we've been adding more features and functionalities to make us continually more attractive for service providers.

We'll take our next question from Matt Hedberg with RBC Capital Markets.

Hey, guys. Thanks for taking my questions and congrats from me as well. Maybe for Mark the product refresh it seems to be moving along nicely and clearly you called out growth in SaaS and something emerging products was strong there. I'm curious if you could drill down a little bit on pricing both within kind of core firewall but also some of the newer products that are seeing quite a bit of growth?

Yes. That's a great question, Matt. We are absolutely selling the value proposition of the entire platform which has all those three evolutions go into an automation, orchestration and consistency and now entirely new consumption model with the application framework. And I mentioned that because that allows us from a pricing perspective to be on the one hand very competitive, but also on the other hand to be able to not have to sell two prices as many, many of our competitors continue to do. So is this example in this quarter that we saw a discounting improve again sequentially in year-over-year. We've seen that for number of quarters now which is fantastic. Our team I think is done a great job of selling to value and selling to the strategic nature of the platform.

It's great and then I'm not sure if Mark Anderson on the call but EMEA looked like it was particularly strong this quarter. A lot of us have been talking about GDPR as a potential driver this year. I'm curious is that showing up is just dialogue at this point or is it actually driving real deals as far as you can tell?

Yes, I am in. GDPR I think or any other phenomena that drives awareness for companies to build better security defenses. There's a good thing for us because it allows us to get in front of people that have budget and show how differentiated we are from our competitors. So I think we've got a good talk track on GDPR and more importantly it's backed up with the supreme, supremely better security. In terms of attaching it to deals I think, I think we've been I think considered in Europe the thought leader for security for a couple of years now. And I think more than anything else just the awareness that customers have about what we can do for them as ramped as we built out a very nice team and great partner covers there.

We'll go now to Gregg Moskowitz with Cowen and Company.

Okay, thank you very much and let my congratulations as well. Mark, more recently seen excessively widened the gap on those [Indiscernible], and I'm wondering if you are seeing any changes in the competitive landscape or in your view is this just a function of having fixtures go-to-marketing through this [Indiscernible]

Yes, Gregg. Kind of broken up there I think the question was competitive differentiation is that summary? It is tough to hear you?

That's exactly right Mark. Just -- the widening gap that we've seen on growth versus your peers. Thanks.

Great, okay, thanks. Yes, well thanks for noticing. Yes, we continue to perform very well in the market we think and we are growing it outside rate relative to the competition and its scale a couple billion dollars. Its size right now so that's not insignificant and I think that's due to the fact that the platform approach we've taken is really resonating with customers. A lot of security vendors all sound and same when they talk about automation and integration and vendor reduction things along those lines, but what we found and we found it to be a competitive advantage for us is the architecture really matters, so we can sit with customer and say this is how we've done it over time . We have a very high degree of confidence because we primarily built most of ourselves that it actually works together, does drive that automation it, does drive their orchestration and increasingly at scale you can see the consistency from network to cloud endpoints as well. It's really resonating with the customers and I think that's showing through with the results.

And if I could just add I think you're comparing the just a vast amount of innovation that our engineering team is cranked out in the last year. If you just think about the new products, new services, new capabilities, the new features and the two new versions of operating system that come out, it really does separate us from anybody else.

Okay, terrific and then for my follow-up, I'm curious since older appliances like the PA-2000 and PA-3000 can run on Pan OS8.X, is that driving some incremental refresh at this point or do you think that it will go in public?

Not, doesn't appear to be the case now and yes I think anytime we have more different or new operating systems and new hardware that gives a great reason to talk to customers and hopefully get them to upgrade things along the lines, but those two things particularly I wouldn't call that, yes.

We will go next to Sterling Auty with JP Morgan.

Yes, thanks. Hi, guys. Looking at the -- I think it's the Billings for a subscription support that grew 24%. I'm just curious any FX or duration type of impact that that would have prevented that from growing even faster and when you look at the first half over first half?

No, Sterling. There is a very minimal FX inside of here and then we priced in US dollars and then on the duration side duration has been very steady for about --it's very steadied about three years for quite some time now.

Okay and then the one follow-up. I think you called out the endpoint plus cloud bookings run rate like run 240. I think at the Analyst Day you talked about a 140 run rate. Can you kind of compare and contrast what was the timeframe for the 140 and is this just seeing a lot more customers moving into production and just buying a lot more expansion that's driving that growth?

Yes, sure. So at the Analyst Day we talked about a $140 million run rate now as the Q4 billing run rate and today we gave you the Q2 billings run rate. So we are trying to do the apples-to-apples along that. You can see it's growing very nicely. It starting contributing pretty well as close to getting to be like nine percentage or ten percentage of total Billings contribution overall, which is great. You can also considering if you strip it out the other portions growing it close to 20% in size of billings as well 9 times bigger. So I think the whole platform is selling very well and as far as which driving they're non-attached, a lot of the capabilities are very good in and of themselves. And I think customers are increasingly realizing the value of the consistency aspect of being able to have the same security outcomes and network cloud endpoints. And then just to make that even better we put the application framework on top of that, and said for all those things that you're deploying from top of the network so you've got consistency, we're going to drive even more value over the top for every dollar you spend with us down there.

And just a point of clarification there 140 was for our cloud and end point which we broke out separately in our Analyst Day presentation .And the number that we provided today included auto focus which was a separate category at Analyst Day.

Which is what? Do you know it?

Yes, 50, sorry, I am sorry $15 million.

Yes. $15 million, sorry at 90%, right. So you add those together, Sterling, so we had $140 million plus $15 million and at auto $155 million blended mix of somewhere between 85% and 90% and now we've put those together into $240 million growing it over 85%.

There you go.

We'll take our next question from Catherine [Indiscernible]

Thanks for taking my question, excellent quarter. Now could you dig a little bit more into the cloud and how differentiated you are from your competitors? It seems to be that's an area that you continue to wide the gap on and particularly what are the cylinders or products or services that are driving and widening that gap? Thank you.

Sure. Thanks Catherine. We've been at cloud security now for over five years in the second evolution which I talked a lot about in the script which is making sure we have that consistency. So when we're talking about cloud security there's a number of aspects inside of there about delivering security from the cloud, using cloud as a third party infrastructure, as well and making sure we can secure that for folks and also making sure that we can provide the same seamless security and third party SaaS applications as well. You kind of think about the approach we've taken, we've been very native with third party providers like AWS and Azure. And now you may have noticed we just announced support for the Google Cloud platform which I talked about in the script as well. So we have all the major platforms covered and inside all this platforms, we think in a very native approach to not only protect I call the networking aspect so that would be M Series but also protecting the hosts we just announced Traps for Linux which is very Linux which is very important in cloud environments, and then also with on an API basis with Aperture for both SaaS and public cloud as well. So increasing things like visibility, compliance and storage security. So we're making a lot of progress at that. You may have also heard me talk about an addition having security competency with AWS, we are the only security of energy at networking competency as well which is kind of interesting because when some security vendors try to go to the cloud they want to just virtualize something. You can take into the cloud as opposed to working very natively with the cloud providers and really using their tools and capabilities as well so that we can do lots of creative things along with them like order scaling and load balancing that really take advantage of their network capabilities as well. So lots and lots going on there we think the cloud is super important. Customers are talking about the cloud for sure, some of them are moving rapidly in that direction and we're absolutely in front of all that we believe with it with the customer base and increasingly thought us thought leaders there and also the technology leaders as well.

I just add one thing there Catherine. It's Mark here. The go-to-market relationships that we have with all three of these large public cloud vendors is really strong, they're becoming very important distribution partners for us.

We will take next question from Ken Tulane Ian with ever core ISI.

Hey, guys. Thanks for taking the question. I wanted to go back on product. I was wondering if you could actually rank order the drivers of product growth in the quarter and how, if at all, you expect that to change in the back half of the year.

Sure. Well, I don't think it's going to change much in the back half of they year, Ken. This is Mark by the way there's really three drivers in there, and I order in this direction the first is expansion opportunities in the customer base, that's simply a magnitude statement when you have this large customer bases we have, and they continue to buy from us along the way for their needs and use cases. That's going to drive a lot of business. And we have new customer acquisition as well. You can see we just put up another close another 3,000 net customers so that's very helpful as well. And then a third is the refresh opportunity which continues to grow over time. And of course adding more customers helps at in the long term. I don't see that changing the rest of the fiscal year there.

Okay. Great. And as a follow-up, you have another hardware release out there. I was wondering if you could tell us when gross margin might normalize.

Yes. It's a great question. So on the gross -- on product gross margin side, there's really two dynamics at play here. So we have the product gross margins on the new hardware itself right, and then we have the mix of the new hardware in the total hardware mix. So the product gross margin declines we've seen for the last few quarters are due to the mix increase of the new hardware. So let me let me break that down for just a second for you. So when we launched new products last year, we're going to naturally start off with lower margins on them and then they're going to improve over time. Now we've seen along the way higher memory and component costs, but even with that dynamic in play we've continued to have modest improvements each quarter since we release the new hardware. And we expect that's going to continue, but at the same time that's kind of be an offset with the mix of the newer of all the hardware, still having more and more new hardware as well, so the mixes will drag down the product risk margins along the way. So we're sitting here at the mid-year with an increased product guide, another great set of new hardware, we just put on a market last week and some headwinds on component pricing so we're expecting that we're going to see the same this mix dynamics to continue throughout the at the end of the year, but we expect the total gross margins to be basically in a zip code where we are today and then of course as you can see we're continuing to manage the business that we didn't get continued operating leverage.

We'll go next to John DiFucci with Jefferies.

Thank you can you can add, a lot of people do, no problem. Kathy, I want to ask you question on the numbers but the numbers are really clean and they look really good so may be go to Mark. Mark, these new products that you just came out with over the last I guess week or two. Do you see I just want to make sure because we try to model this -- do you see these more as evolutions or upgrades to existing products or these brand new offerings that sort of fill some holes in your current portfolio on the range of next generation around the range of firewalls?

Yes. I think of the kind of both ways John. So as we said in the past if you or the way we think about it with customers is customers are going to have various use cases that you're trying to solve for overtime and then these use cases have different price performance requirements, if you want to be competitive in the market right. So if I laid out all the hardware capabilities and Panorama M series, I should throw in there as well, so laid them out in the table where these kind of get left to right you know smaller form factors and throughput all the way up there really big ones, and then what we've been doing is filling it in every year right along the way of putting more and more capabilities in there or form factors in there at the right price performance or the use cases, and that of course then makes us more competitive. So the competitors can't come in over top or underneath us from a pricing perspective with throughout. So that's what we would expect that we continue to into the futures just make sure that we're always solving for that. Those don't stand still the SSL decryption needs for example, as those go up over time, that's going to drive up throughput, so we want to make sure we got the right throughput capabilities there.

Okay, okay thanks in it and if I could I know you give some billings metrics but when we take a look at this and we kind of try to back into new product excluding refresh and new subscriptions excluding renewals, the new product numbers look stronger than the new subscription. And, first of all, I guess is that right I guess directionally and what is -- is that do I mean now if you're seeing some benefit from product refresh that would be one cause of that but just is that what's happening here?

I think well I'm not sure there's -- I am not sure exactly the questions. Let me try to answer what I think it is though but you know with when customers are purchasing from us or starting out with us right on purchases if you look at the lifetime value creation over time, it takes time to get maximum lifetime value creation which by the way is not standing still, right. So when you go into the mix of what customers are buying from us over time with hardware services with attached, non-attached services and then they're going to lap over, they're going to renew their support, they renew subscriptions because a chance to sell more stuff the lifetime value I think naturally grows over time with our customers.

We will take our next question from Rob Owens with KeyBanc Capital Markets.

Great, good afternoon, everyone. I was curious on Traps and some of the big wins you saw. Are you the exclusive --are you exclusive to the endpoint at that point? Are you complementary to someone else? And in those bake-offs, who are you seeing typically?

Sure. Hey, Bob, it's Mark. I'll take those in reverse and as far as we see, we see everybody a lot primarily we're going to see -- we're going to see the legacy incumbent folks in there who are providing AV protection and our best and doing a good job in taking them out. And then we see a lot of next-gen folks and there as well next-gen import providers who are also trying to do the same thing. And in your first question, it's a mix. Sometimes we get to be the -- we get to be the only provider when we're done. Other times we may be run as a complement or sometime because you have to think of endpoints as suites as well because there's other capabilities endpoints that we don't have like the LP full-on TLPK capabilities for example so that we continue to run different endpoints providers, but not specifically for the security functions we've got.

And second you mentioned that when your subscription support up front it's typically three years. What is look like on a renewal?

Renewals have been very consistent for quite some time on a steady range it's not really changed. So it's been pretty consistent the overall renewals as heard us say about three years.

That's three years as well okay thank you.

I am sorry Rob, just to be clear, the overall duration is about three years and inside of that for renewal durations those have been in a steady range for quite some time inside of that number, yes.

Okay.

Just want to clarify.

We'll take our next question from Fatima Boolani with UBS.

Good afternoon. Thank you for taking my question. Mark, a question for you, you spoke about the first ruggedized appliance in your portfolio about last week. And I'm wondering how you think about this broader opportunity around protection of critical and industrial control systems? And maybe your perspective on why this particular area has kind of been habitually under invested and follow-up Kathy if I may.

Sure, great. Yes, so on the questions really about the PA820R which is the ruggedized version of PA820 which is a great opportunity for us. A lot of our customers which are in environments where it would we consider these not just IT capabilities but OT capabilities, ICS state environments, harsh environments, where the line is blurring between IT and OT, they want to have the same capabilities that Palo Alto Networks provides, but they want them in those harsh environments and number of folks asked us when you ruggedized 220 because that's a great form factor for oil rigs for example in different places it might be you know utility substations and things along those lines. So they actually should have been doing that kind of themselves with different contract manufacturers or ruggedized equipment for us. So we said well we can do that so that was the impetus to launch the PA820. Now what that does for us is with customers who already like our capabilities, it gives us whole new outlets of where to install this hardware because it can now go into those environments or require those ruggedized capabilities. Kathy, I'll let you take over the next part of it.

Thank you. That's really helpful. And Kathy is the portfolio expands and begins supporting with clouds services like GlobalProtect. And what are the implications for your CapEx profile, and how are you thinking about that this year and at a qualitative level for next year in the years out?

Yes, thanks. We are definitely investing in our application framework as we look to deliver more cloud delivered services. Obviously, that requires a bit of infrastructure investment. And so the $100 million CapEx number that we've provided as full-year guidance in fiscal 2018 definitely includes an investment in that infrastructure. And I think we would expect that to be ongoing and continue as we build out the application framework.

Yes, and logging service as well so some of the new services that were brought to market are a good amount of infrastructure and back end like logging for example that's not an expensive to do that.

For our next question, we'll go to the Jonathan Ho with William Blair.

Good afternoon and congratulations on the strong result. Just wanted to start out with the salesforce and in terms of the sales execution challenges that you guys saw last year. How should we be thinking about in sort of the room for productivity enhancements and maybe where we are in terms of correcting those challenges?

Hey, Jonathan. Mark Anderson here. Thanks for the question. Yes, so I think on the salesforce rework that we started working about a year ago I think I got really compliment Dave Peranich for doing a terrific job of restructuring and getting the right butts and seats to focus on the right customers and clearly driving the right outcomes. From a productivity standpoint, very happy with the productivity improvements that we've seen. We talked about that in Analyst Day and we still see it will continued improvements there. I think with all the new services and the new products that we have we've got more arrows in the quiver for the sales reps and out there and I think we're optimistic in being able to see improvements there.

Yes. We are expecting in our guide we gave for the second half year as well that there will be continued productivity improvements.

Got it and then and as we look at sort of the tax rate reduction, as well as the strong balance sheet that you have. How should we think about use of capital on going forward?

Yes. We take a very traditional approach that Jonathan, but really looking at three possible uses of capital. The first and most important in our opinion would be to invest back into business assuming we can get the right rate of returns on that. We invest very nicely into business as you can see involves continuing to drive leverage and capturing market share along the way to do that so we feel like that's working out for us. The second priority would be if we see technology capabilities in the market that we like that we think could help accelerate the evolutions that we've been driving for some time. We've demonstrated the ability to go to market and do some M&A to do that and could be the case in the future for us. And then the third is if we are not doing the first two, we've also demonstrated the ability to return by the shareholders primarily through stock repurchases while maintaining a good healthy balance sheet for any offerings.

We'll go next to Anne Meisner with Susquehanna.

Hi. Thanks for taking my question. At Analyst Day, you talked about bifurcating AI tools along with your customer data to better implement some customer targeting program. Can you give us an update on that and what your strategies have resulted from that initiative? And then in particular, as it relates to that refresh cycle, whether you think its helping you optimize that opportunity?

Yes. And that's a great question, and really appreciate the fact that you took note that it Analyst Day because we're really a data driven company here. So lots of mathematicians running around and including in the marketing department as well as their CIO organization, which are using and harnessing the same kind of AI machine learning capabilities that you are coming through our product sets. So the number of the things that we talked about at Analyst Day that our tools for our sales team to use like things called quota crusher for example, and the deal doctor those are using AI capabilities to tell our sales rep what is the next thing you should do with this customer or recommend for example or if you want to maximize your earnings this is how do you how to do that. And those are being very heavily used by our team as well as our partners at the better and better effect. So as we continue to train those tools they get better so again going back to the last question that just came up in productivity, I would definitely put some of the productivity growth that we're seeing from the sales team in this bucket which has given them fantastic tools to use in order to grow the productivity.

We will next to Saket Kalia with Barclays.

Hey, guys, thanks for taking my questions here. First maybe for you Kathy just a quick accounting question on product. Could you just talk about how the accounting for VM series works? Meaning could we see any carve out of VM series in the product line as that business gets bigger or perhaps his accounting rules change. Just any color and how VM series could or could not impact a product line down the road?

Well, the VM series is really should not change the categorization of where we put revenue one way or the other.

Yes. Saket, you may have heard in the past you know we talked about the VM Series historically a long time ahead like the two flavors are perpetual, right and non-perpetual. And the perpetual piece would go into product that's pretty much going on like. It's just almost nothing there, so every time you here's talk about the VM-series it's going to go into a ratable line for us.

Got it, that's super helpful. Maybe a follow up for you Mark. Kind of a follow up from last quarter actually but can you just talk about how the application framework is changing conversations with customers and maybe tying it to this quarter whether the application point frame is actually helping the core network security business at all?

Yes. It's -- I think it's definitely helping their overall business across the board. And as far as the conversation with customers a 100% of time and I'm not exaggerating on that I've briefed hundreds and hundreds of customers as Mark has well, we hear the same thing which is them saying we have this seemingly insurmountable challenge, which is how do we harness new innovation which we know has to come. We know no one company can do it but we can't operationalize it because we can't run one more thing right. So this application framework sounds like you figured out how to solve this problem substantially for us. So we Hope you get this right, and that's very consistent. Now this afternoon, we know we're trying to sell something this afternoon, it really goes back to the second evolution on consistency, which we're doing a great job at for each of the capabilities, the consistency of security and now we've just given the customer a really powerful reason if they're going to think about us versus that endpoint provider, that firewall provider or that cloud provider why you go with Palo Alto Networks in order to future-proof your investment, which is now they're going to put the application on top of. So if I buy their firewall today, their endpoint today, their end today their cash capability today, they're going to continue to bring more innovation to that purchase and make that purchase more valuable for me for every dollar I spend with them when I deploy them that way. So it's been very, very positive. I think that's really helping us in the market.

We take our next question from Keith Weiss with Morgan Stanley.

Thank you. This Melissa Franchi calling in for Keith. Thanks for taking my question. Mark, I am just wondering if you're seeing any change in customer behavior around refresh? And I'm mostly interested in if you're seeing any customers that are opting to instead deploy a VM series instance versus a physical deployment and what would be sort of the use cases around that?

Now we see that -- we we've seen everything go in many directions Melissa. We kind of see it's the cloud side of the business, it grow at VM series, the hardware side it grows -- it's is growing as well, but back to this consistency thing if we get a chance to do something for customer they're more often not or going to use this in these - in the environment everywhere. So we gave an example in a car that was kind of interesting about a customer who was a large company that new to us as a customer never want anything, first thing they bought was in the AWS marketplace for VM series, and then over time after we saw them there we contacted and said, how are you doing lead gen for us. And we just closed the seven-figure deal with them on front right because people are living these hybrids -- worlds in hybrid environments. You kind of see it going in the physical, physical of VM; people are going to operate these hybrid environments for quite some time. We think it's been beneficial for us.

Okay, thanks. And just one quick follow-up for Kathy. It was helpful to see that the tax guidance for the fiscal 2018. I'm just wondering if you could put some color on what we should think on the impact to cash taxes because as far as I understand you still have NOLs.

Yes. That's right. We do have NOLs and we don't expect to be a cash taxpayer or a significant cash taxpayer for the next four years or so. We mentioned at Analyst Day that we expect to pay about $10 million to $25 million per year over the next four-ish years and that doesn't change with the new tax law because of the NOLs essentially.

We will go next to Philip Winslow with Wells Fargo.

Yes, thanks guys for taking my questions and my congrats again on just an awesome quarter. I have a question on gross margins and most my other questions have been asked already but Mark you laid out sort of the impact of the newer appliances versus some of the older appliances, and the effective on gross margins but as you sort of look up and down cause that way the appliance set to called the service provider large enterprise branch office et cetera. How do you -- how should I think about the differential in gross margins there and as you think about what sort of impacting gross margins over the past years, and as you kind of think about that guidance going forward. How do you think about that mix call it between up and down the appliance range?

Yes. I think a better way to think about it so is not so much the size of things it's really about what goes into them from a component perspective. It's and there's a mix of components and all these things right. They don't -- they're not all the same across all the devices either. Though it's not just about like a small thing versus a big thing, usually, and I see this in case, newer things right will have lower product gross margins than things that are much more mature over time because we continue to drive economies scale, the components your pricing improves over time things along those lines. So I think about it that way and the mix comment I was making was as the mix of our hardware is goes more to the newer things that we've developed, and we can see we are although performing very nicely on a hardware side, that's positive for the business of course, it's got some short-term impacts on the product gross margins because that mix is larger inside there. Even though we're continuing to improve the gross margins on those products, every single quarter as well.

That concludes today's question-and-answer session. At this time, I'll turn the conference back to Mr. Mark McLaughlin for any closing remarks.

Thanks operator. Appreciate that we're going to thank everybody for your time this afternoon and I know we're going to see many of you over the coming weeks. Look forward to that. Hope everybody has a great evening and thanks so much for joining us on call today.

This does conclude today's conference. Thank you for your participation. You may now disconnect.