Fortinet Q2 2021 Earnings Call Transcript

Quartr
Provided by Quartr
July 28, 2021

There are 14 speakers on the call.

Operator

Good day and thank you for standing by. Welcome to the Fortinet Second Quarter 2021 Earnings Call. At this time, all participants are in a listen only mode. After the speakers' presentation, there will be a question and answer Please be advised that today's Conference is being recorded. I would now like to hand the conference over to your speaker today, Peter Salkowski, Vice President of Investor Relations.

Operator

Sir, please go ahead.

Speaker 1

Thank you, Catherine. Good afternoon, everyone. This is Peter Sogowski, Vice President of Investor Relations at Fortinet. I'm pleased to welcome everyone to our call to discuss Fortinet's financial results for the Q2 of 2021, which we are hosting from inside of our new building. Speakers on today's call are Ken Xie, Fortinet's Founder, Chairman and CEO and Keith Jensen, our Chief Financial Officer.

Speaker 1

This is a live call that will be available Before we begin, I'd like to remind everyone that on today's call, we will be making forward looking statements, And these forward looking statements are subject to risks and uncertainties, which could cause actual results to differ materially from those projected. Please refer to our SEC filings, in particular, the risk factors in our most recent Form 10 ks and Form 10 Q for more information. All forward looking statements reflect your opinions only as of the date of this presentation, and we undertake no obligation and specifically disclaim any obligation to update forward looking statements. Also, all references to financial metrics that we make on today's call are non GAAP unless stated otherwise. Our GAAP results and GAAP to non GAAP reconciliations is located in our earnings press release and in the presentation that accompanies I will now turn the call over to Ken.

Speaker 2

Thanks, Peter, and thank you to everyone for joining today's call to review our outstanding Q2 2021 results. Billings increased 35 percent to RMB 961,000,000 driven by solid execution and was the best it has been since 2015. Securius demand accounted for 14% of 2nd quarter billings. Total revenue grew 30% to 801,000,000 With product revenue up 41%, product revenue growth was the highest for nearly 10 years. Free cash flow was $395,000,000 a quarterly record level.

Speaker 2

With strong business momentum, we remain focused on growth. Today, we announced expansion of our FortiCare and FortiGuard security services, adding a new security service called FortiTrust. Fuditrust security service offer user based licensing that follow the user across the organization's entire security platform. This enable organizations to easily manage and secure across all network endpoint and cloud, which traditionally has been side loaded. Initial service level are being offered for 0 trust network access and identity verification.

Speaker 2

We have the current FortiCare security services, which cover all Fortinet security fabric product with 3 level of services to include in 20 fourseven technical support and timely issued resolution. Additionally, For the current security service has been fine tuned for different segment with added individual services for enterprise, Bundles for commercial and packages for SMB. Leveraging industry leading threat intelligence from FortiCloud Lab, Foodica's security service offer market leading AI enabled security capability that regularly adjust Protection across the Fortinet secondurity fabric. Today, we announced a new FortiGate 3500F, The industry's 1st high performance next generation firewall with integrated Zero Trust Network Access and Advanced Network Protection Powered by the Fortinet MP7 ASICs SPU, the 7500F offers an average 6 times more performance The other competitive products based on our security computing. This makes the 3400F The best protection for high speed internal network and data centers.

Speaker 2

We continue to see the momentum and adoption of our SD WAN, Zero Trust Network Access and Cloud Solutions among the world's largest service providers. In May, 49 was recognized as the winner of the Microsoft Security Customer Impact Award. Last week, 49 was named Google Cloud's 2020 secondurity partner of the year recognized for innovative thinking outstanding customer service and best in class use of our Before turning the call over to Keith, I would like to thank our employees, customers and partners worldwide for their continued support and hard work.

Speaker 3

Thank you, Ken. And to add to your comments, we should note that as in the prior quarter, Billings growth, product revenue growth and total revenue growth all accelerated sequentially. In fact, all three growth rates were at 5 year for net highs And product revenue growth was at its highest in over 9 years. Okay. Let's start the more detailed Q2 discussion with revenue.

Speaker 3

Total revenue of $801,000,000 was up 30%, driven by industry leading product revenue growth of 41%. The product revenue growth was broad based across geographies, FortiGate and non FortiGate products and across use cases, Illustrating market acceptance and customer demand for our integrated single platform security fabric strategy across our customer infrastructures. Our financial strategy includes a rule of 40 target. We target the total of the revenue growth percentage and operating margin to be at least 40. In the Q2, strong demand and execution drove this actual total to be a rule of 55.

Speaker 3

FortiGate product revenue growth was 40%, while we continue to see robust growth from our secure SD WAN functionality. Majority of the growth was driven by FortiGate revenue from other capabilities, which are embedded in the FortiGate operating system. Non FortiGate product revenue growth was over 40% for the 2nd consecutive quarter and was driven by strong growth from our integrated security fabric products. One additional comment on our product revenue growth. Our product revenue growth was a reflection of our continued strong organic growth And not the result of a few large deals, drawing down backlog, nor an unusual number of delayed transactions from the prior quarter or pulled in from future periods.

Speaker 3

Service revenue of $503,000,000 was up 24%. Support and related services revenue of 230,000,000 was up 26%, while security subscription services revenue of $273,000,000 was up 23%. Moving to the mix of FortiGate and non FortiGate platform revenue. FortiGate product and services revenue increased 26%, Driven by very strong demand for both branch and high end FortiGate products. High end products included 10 NP7 powered FortiGate models, Representing approximately 25 percent of high end FortiGate shipments.

Speaker 3

Our ASIC driven FortiGates Give customers 5 to 10 times more computing power than firewalls running on common CPUs. The advanced computing power creates additional speed And capacity to continue to add functionality to our operating system, further driving our price for performance advantage. The combination of the ASIC advantage and the common operating system across products can enable vendor consolidation, lowering total cost of ownership and increasing automation. Non FortiGate products and services revenue grew 39% And accounted for approximately 30% of total revenue, up over 2 percentage points. The integrated security fabric consists of complete range.

Speaker 2

Could you close that door?

Speaker 3

A little rehearsal for all hands meeting later on today, folks. So you've got an inside scoop on what Patrice is going to say. Let me start again, if I may. Non FortiGate product and services revenue grew 39% and accounted for approximately 30% of total revenue, up over 2 percentage points. Integrated securities fabric consists of a complete range of form factors and delivery methods, including physical and virtual appliances, Cloud, SaaS and perpetual software as well as hosted and non hosted solutions.

Speaker 3

Together, they provide a range of security solutions and form factors, Enabling integrated protection for the hybrid environments and the expanding digital attack surface from network data centers to endpoints to the cloud. Let's turn to revenue by geo. To summarize on Slide 5, revenue in EMEA increased 34%. The Americas revenue increased 29% And APAC posted revenue growth of 24%. Product revenue growth for both the Americas and EMEA regions was over 40%.

Speaker 3

Moving to billings. 2nd quarter billings were $961,000,000 up 35%. We saw strong growth in both the FortiGate and non FortiGate segments of Security Fabric platform. The FortiGate segment delivered billings growth of over 30%, accounting for 71% of total billings. As shown on Slide 6, branch and high end FortiGates posted very strong billings growth.

Speaker 3

The non FortiGates segment accounted for over 29% of total billings And delivered billings growth of over 45%, driving a 2 point mix shift to non FortiGate products and services. Given the continued strong performance, we believe our non FortiGate platform is on a pace to be a $1,000,000,000 business this year. Secure SD WAN billings represented 14% of total billings and is a key functionality for an integrated Sassy solution. In terms of billings by geo, EMEA outperformed all geos, followed by the Americas and APAC. Europe had a very good quarter And growth in the Americas was driven by the United States, which was up sequentially by more than 30 percentage points.

Speaker 3

Latin America continued to recover from the pandemic induced slowdown, posting billings growth in the mid-20s for the 2nd consecutive quarter. The average contract term was approximately 28 months, up 2 months from the Q2 of 2020 and 1 month from the Q1 of 2021. Deals over $1,000,000 increased from $59,000,000 to $79,000,000 and the pipeline for deals over $1,000,000 continues to look good for the remainder of the year. Secure SD WAN deals over $1,000,000 increased from $13,000,000 to $19,000,000 Moving to worldwide billings by industry verticals. Billings by vertical illustrate the diversification in our business model and importantly suggest the current threat landscape is driving security investments And industries that may have historically shown lower investment levels.

Speaker 3

For example, the verticals that have historically not been in our top five Combined for billings growth of over 75%. Service providers accounted for 14% of total billings and were up 25%. Moving back to the income statement. Product revenue growth of 41% drove a 3 point shift in the product and services revenue mix And along with it, a gross margin decrease of 160 basis points to 77.5%. Product gross margin improved 70 basis points to 61.7.

Speaker 3

Services gross margin decreased 160 basis points to 86.9 With data center investments in FX accounting for about 100 basis points of the impact. Operating margin of 25.4% The top end of the guidance range despite a 3 50 basis point headwind from the gross margin decline, a weaker U. S. Dollar and increased travel and marketing event costs. We ended the quarter with a total headcount of 9,043, an increase of 17%.

Speaker 3

Moving to the statement of cash flow summarized on Slides 78. Free cash flow for the 2nd quarter came in at a quarterly record of 395,000,000 Benefiting from strong revenue growth, good month 1 linearity and lower capital expenditures. In the quarter, we repurchased approximately 455,000 shares of common stock for a total cost of $92,000,000 at an average share price of approximately $201 The remaining share repurchase authorization at the end of the second quarter was $921,000,000 with the authorization set to expire at the end of February 2022. We ended the first half of the year with total cash from investments of $3,400,000,000 an increase of $1,700,000,000 The increase includes the proceeds from our $1,000,000,000 investment grade debt issuance during the Q1 of 2021. DSOs returned to pre pandemic levels, Decreasing 7 days year over year and 15 days quarter over quarter to 66 days.

Speaker 3

Inventory turns increased to 2.7 times From 2.2 times, reflecting strong product sales in the quarter. Capital expenditures for the quarter were $24,000,000 and We have started to move into the new Sunnyvale building. We estimate 3rd quarter capital expenditures to be between $65,000,000 75,000,000 Which includes a $30,000,000 payment for the new campus building. We estimate 2021 capital expenditures to be between $175,000,000 $200,000,000 With the acceleration of the growth and a little more understanding of the post pandemic work patterns, we're turning our attention to reviewing our facilities footprint The needed office and warehouse capacity in the U. S.

Speaker 3

And Canada. As we work through this process, it is possible that our estimated capital expenditures over the next few quarters will increase as we prepare for the next phase of our growth. Looking forward, our goal remains to balance growth and profitability. And given the growth opportunities that we believe lie ahead, we continue to expect to tilt our bias within this framework more towards growth for at least the next several quarters. The opportunities we see are supported by a strong pipeline, Increased sales effectiveness, the growing success with a single integrated security platform strategy and the convergence of security and networking, The response to the current threat environment and our development efforts, which include continuing to invest in our ASIC advantage, which Enables the shared operating system across the Security Fabric platform, drives our price for performance advantage, increase the capacity to add features and functions while maintaining price I'd like to review our outlook for the Q3 summarized on Slide 9, which is subject to disclaimers regarding forward looking information that Peter provided at the beginning of the call.

Speaker 3

For the Q3, we expect billings in the range of $940,000,000 to $960,000,000 revenue in the range of $800,000,000 to $815,000,000 non GAAP gross margin of 77.5 percent to 78.5 percent non GAAP operating margin of 24.5 25.5%, which includes an estimated 200 basis point headwind from foreign exchange and increased travel and marketing costs Non GAAP earnings per share of $0.90 to $0.95 which assumes a share count of between $169,000,000 171,000 We expect the non GAAP tax rate of 21%. With that, we are raising our 2021 guidance and expect billings in the range of $3,870,100,000 to $3,920,100,000 which in the midpoint represents growth of approximately 26%. Revenue in the range of $3,210,000,000 to 3,250,000,000 which at the midpoint represents growth of approximately 24.5 percent. Total service revenue in the range of $4,045,000,000 to $2,075,000,000 which represents growth of approximately 23% and implies full year product revenue growth of 28%. Non GAAP gross margin of 77% to 79%.

Speaker 3

Non GAAP operating margins of 25% to 27%, which includes an estimated 200 basis point headwind from foreign exchange and increased travel and marketing costs. Non GAAP earnings per share of $3.75 to 3.9 which assumes a share count of between $168,000,000 $170,000,000 We expect our non GAAP tax rate to be 21%. We expect cash taxes to be approximately $90,000,000 Along with Ken, I'd like to thank our partners, customers and the Fortinet team For all their hard work, execution and outstanding success in the first half of twenty twenty one. I'll now hand the call back over to Peter for the Q and A session.

Speaker 1

Hey, Heath. Operator, Catherine, we're ready to open the call for questions, please.

Operator

Sure. And our first question is from Brian Essex of Goldman Sachs, sir, please go ahead.

Speaker 4

Great. Thank you for taking the question. And guys, congratulations on the results. Really nice set of results this quarter. Maybe to start off, Ken, I know you've talked for years about not having Exposure to firewall refresh cycles within your business.

Speaker 4

Could you maybe unpack a little bit the product revenue performance? Are you starting to see Perhaps some exposure to the refresh cycles of others? Is this more rip and replace infrastructure upgrades or Maybe if you can maybe give us a little bit of an understanding of what's going on behind the product revenue growth this quarter?

Speaker 2

Yes. Thanks, Brian. Great question. 3, whether during the pandemic after the pandemic probably in some kind of a whole structure changing. It's no longer the traditional border kind of firewall will be enough.

Speaker 2

You have to expand into the one side like secure SD WAN, the 5 gs, And also internal have to do like internal segmentation, replacing the switch with secure switch and the WiFi to prevent all this kind of ransomware or kind of internal attack. So that's where and also consolidation also And also need to have a integrate like a different party infrastructure security integrate together to protect the whole So that's where we see it's a big Chen, for the whole architecture of how to architect the new protection architecture to protect the whole infrastructure security So that's probably different than just refresh the traditional firewall, but it's the new expanded Structure need to be have all protection there. So that's what we see like the product we announced today is 100 Fs Mogo inside The high speed network environment has to do all this kind of internal segmentation within data center Action and all these kind of things. And then also we see very strong growth, whether the secure SD WAN and also the 5 gs growth. That's drive a lot of branch office, work on home solution there.

Speaker 2

That's where the unit grow probably even much faster there. So maybe this is the whole infrastructure being changed, obviously call it security driven networking study kind of more adopt by the both enterprise and also A different kind of vertical.

Speaker 4

Got it. That's super helpful. Maybe to follow-up, service provider was slightly lower as a percentage of revenue this quarter. I understand that on the product revenue side in the high end you saw a lot better growth, but should we think about that segment particularly to The extent that they might be selling through for Sassy or you might be getting better traction with Opaque, how should we think about growth Service provider market, is that still to come or is that a more stable kind of mid-20s grower segment for you?

Speaker 2

Actually, we've seen a ramp up stage, still in the early stage of ramp up compared to last quarter probably like down about 15%. This quarter grew about 25%. So starting ramp up, like I mentioned, they are kind of a building infrastructure, whether for the 5 gs, SD WAN or SASE, Which we have a different strategy. Our strategy actually quite a different and probably very different from our other player. So we have a dual strategy.

Speaker 2

We are probably the only one working with service provider to building their SASE. At the same time, Like the service revenue, we kind of lower the margin that will be there, also investing some of our own infrastructure. If some customer don't have a service Provide our one to own working with us directly, we also have a kind of own kind of SASE solution there, which also integrate with the FortiOS. Inside FortiOS, they have a building size, Zircross network access and some other part. It's also kind of a different Then our competitor and eventually, we also hope we can use ASIC or salary to add additional computing power to our kind of own SaaS solution there.

Speaker 2

So that's where we feel it's a long term investment, but once we have it, we have a huge advantage compared to other competitors. All

Speaker 4

right. That's helpful color. Thank you very much and congrats again.

Speaker 2

Thank you.

Speaker 5

Catherine?

Operator

Yes, sir. Our next question is from Hamzah Fodderwala of Morgan Stanley. You may go ahead.

Speaker 6

Hey guys, thank you for taking my question. I had a follow-up regarding the prior question on some of the drivers of product revenue growth. So Ken, as your customers start coming back into the office or as we move into this more hybrid work environment, you talked a lot about these larger Network transformation deals. I was wondering what do you see the pipeline looking like for those larger deals heading into the back half and beyond? And do you think that Some of the things that we saw in the past 12 to 18 months is going to be an accelerant for those more larger infrastructure type deals.

Speaker 2

Yes, we see the pipeline very strong for the larger multiple product deal, which like Porsche, I mean, I cover multiple part of infrastructure. And also the product revenue growth like 41% is also very strong. We feel that Our product is very different than the traditional or some of our competitors using the CPU only. So we have the latest CPU front industry, but also we develop Basic in the last 21 years. Just like the product we announced today, the CERT-500F based on our calculation, we call it secure computing region, basically for Same cost was the function performance compared to other competitor or industry average.

Speaker 2

So we have a 6 times better performance Basically like because the computing power advantage is huge for our own ASICs. So that's what changing the landscape of like The product, whether it's network security product or some other leveraged ASIC, it's a huge this huge company and power gave us Much better more function and better performance that can easily replace a lot of our competitors. But at the same time, we could see the expansion total addressable market, whether it would work Our whole kind of a secure internal network inside the company, inside the data center, which also drives a lot of high end product growth. So the Product percentage also we see probably pretty high, maybe the highest in the last few quarters or even last few years.

Speaker 6

Got it. That's helpful. And maybe just a follow-up question for Keith or Ken. Keith, you mentioned The operating margin in the back half having about 200 basis point impact from FX. I was just wondering just on your spending Plans around hiring, what you're seeing there is obviously a very competitive market for talent these days and I'm wondering if that's been factored all into your guide?

Speaker 3

Yes. I think we will obviously pay attention to our recruiting and to our attrition rates. I think the metric that we gave was that our Overall headcount increased 17%. I would offer that sales headcount actually grew significantly more than that. So I don't I think that We're in a bit of a sweet spot and it kind of relates to what Ken was saying just a moment ago in terms of the success that we're having.

Speaker 3

I think you can read Through to the high end FortiGates is probably being data center deployments and probably taking advantage of some competitors that are going through a refresh cycle. And at the same time, some of the branch, FortiGates may be reflective of digital transformation. And I think that the audience of sales people And that and see the opportunities there.

Speaker 6

Thank you.

Operator

And answer our next question from Sterling Auty of JPMorgan. You may go ahead.

Speaker 2

Yes. Thanks, guys. For my

Speaker 1

one question, I just wanted to dive into Keith in your prepared remarks, you made the comment that the majority of growth was driven by FortiGate revenue from Other capabilities embedded in the operating system, I wondered if you could kind of peel back the onion there. What does that mean? And what capabilities were you referring to that were in particular demand in the quarter?

Speaker 3

Yes. I think that we've tried to make the point in the past that the Some people think about the firewall somewhat simplistically. We probably track close to 12 to 15 different firewall use cases, Whether you want to talk about micro segmentation, IPS, etcetera, all of those, the totality of those, The growth there was contributed more if you will than SD WAN. SD WAN itself still obviously contributed very nicely at 14% of our total billings, Which probably puts it close to about 35% or probably 55% growth. So I think there's a long list of things that a firewall is used for And we were very pleased with success that we saw throughout that suite of offerings.

Speaker 2

Also especially the FortiOI7, we are building 0 Trust manual And the building SaaS there, we see very strong interest in this area, both from the service provider, from enterprise, from work from home solution there.

Speaker 1

Understood. Thank you.

Speaker 2

Thank you.

Operator

And sir, our next question from Rob Owens of Piper Sandler, you may go ahead.

Speaker 7

Great. I'd like to thank you guys for taking my question. And Following the lead of Mr. Roddy, I'd like to ask one question. Could you elaborate a little bit on your commentary around some of these nontraditional verticals That are starting to tick up meaningfully in spend.

Speaker 7

Is this more one time in nature or these verticals are just starting to wake up to Some of the security issues that we're reading about in the media every day. And to that, maybe you could comment a little bit around your OT success and your strategy there. Thanks.

Speaker 3

Yes. And then Rob, I think you did a very good job of laying all the dots to connect there. We're looking at industries or verticals such as manufacturing, transportation, Energy utilities or what have you, and to see the dramatic growth that we saw in that segment of the business. We've historically talked about our top five Financial services, government service provider, tech and retail, and they've been very consistent about that 65%, 66%. But we saw a significant shift this quarter To those others, and it was just the sheer growth that we saw in those others.

Speaker 3

And the point that you alluded to OT. OT performed very, very strongly in the quarter, And I think that's consistent with what we saw with that vertical growth and those other verticals that I just mentioned.

Speaker 7

Thank you very much.

Operator

Our next question from Shaul Eyal of Cowen and Company, you may go ahead.

Speaker 8

Thank you. Also single question on my end. When we look at the billing upside revenue upside you've printed, can you unpack for us the mix Between new logos and the current installed base, any qualitative color

Speaker 5

and discussion will be appreciated.

Speaker 3

Yes. Shaul, it's Keith. New logos were very strong in the quarter, probably up about 50% year over year. And I've given numbers in the past to kind of suggest that 5,000 customers that we had in the quarter, obviously, a very strong quarter is going to be north of that, 1st part of the response. 2nd part of the response, you would not normally expect to see that the new customers in the initial quarter Would be significant contributors to revenue, but rather contributors to revenue growth over a longer period of time.

Speaker 3

But there was A very strong performance from the new logo segment in terms of customers that signed up with us in the quarter.

Speaker 8

Thank you.

Operator

Our next question is from Saket Kalia of Barclays. Please go ahead.

Speaker 9

Okay, great. Hey, thanks for taking my question here. Ken, maybe for you, you touched on this a little bit in your prepared remarks, but Can you just talk a little bit about the new pricing options that you announced recently? Specifically, Do you feel like there is demand for that per user pricing for kind of access to the broader FortiCare and FortiGuard Portfolio and what was sort of some of the early feedback as you maybe tested those options?

Speaker 2

We do see going forward especially like go from home or remotely, the per user license which can Cover multiple device including the mobile operating own device to work from home and also internal inside enterprise company there Like a cover multiple, like not just a 40 ks that it goes through to the Zero Trust network access, but also Some other like a web or mail, some other application or kind of some part of infrastructure data center they need access. So that's per user license will make much easier for the user, for the customer to really Using all these security service in the multiple part infrastructure, multiple cover multiple product there. So So that's where we feel this is also very important add on top of the current FortiCare, which Cover all the product we have and also the FortiGuard cover the product need real time update on the subscription, all these kind of things there. So we feel this FortiTrust is probably the trend in the future, but still need some time to ramp up. Especially we see the Zero Trust Network Access starting to have a pretty quick growth opportunity, which The FortiGate already have all this built in.

Speaker 2

And also the identity, how to like kind of Make sure that then it's across multiple infrastructure and easily kind of management user, we feel all these tool service also kind of starting to get very important. It's still some kind of ramp up, but we do see there's a huge interest and demand from the customer. That's also the reason We launched this E42 Trust service.

Speaker 9

Got it. Thank you.

Speaker 2

Thank you.

Operator

Our next question, sir, from Michael Tuirets of KeyBanc. You may go ahead.

Speaker 10

Hey, everybody. Huge quarter, of course. I think for both Keith and for Ken, a lot of people have been circling around and trying to understand the strength and the upside. But I guess I'd like to Try to compare where the demand was last year during 2020 to where it is this year and why it seems so much stronger. Has there been a shift Say from remote access focus to more breach or what has changed both qualitatively and quantitatively that we're seeing this acceleration?

Speaker 2

Last year, they probably more like in the rush supporting whatever can make it Working remotely. But this year, they did definitely see the infrastructure need to be upward and to be changed to most important this long term. So that's where you see a lot of new infrastructure design and how to support and not just work remotely, but also secure a whole structure different part of infrastructure from the WAN access to the internal segmentation and also Even the 5 gs or IC WAN or internal WiFi. So there's just a lot of new security architecture Cover multiple part of our product, it's very, very strong interest. And also Keith mentioned the OT, some other areas because of whether the 5 gs IoT OT, Also that part also was very strong.

Speaker 3

Yes, Michael, I think I would agree with Ken completely and maybe just add. If you think back about Q2 2020 specifically, at least for us, it was a quarter that was characterized probably by A lot of software. We did very well with our software in the Q2 last year. But on the flip side, anything that required somebody to be on premise in a data center or Taking on a large deployment or a phased appointment or something like that. Q2 of last year, there really wasn't much of that.

Speaker 3

Obviously, today, I think it's A year later, it's a very, very different environment in that regard. And I do think you're also seeing the threat environment and things like the OT part of the business do very, very well.

Speaker 10

Great. Thanks, Ken.

Operator

Our next question from Jonathan Hu of William Blair, you may ask your question.

Speaker 1

Hi, good afternoon. I just wanted to understand if You're running into any issues around the supply chain or potential chipset shortages. And does this lead to any potential impact Your order cadences

Speaker 8

at all.

Speaker 3

John, I'd love to say that we're completely immune to chip shortages and such, but I can't say that. Yes, I do think that as we talked about last quarter, the fact that our inventory turns hover around 2 or suggested that we have 6 months of inventory on hand. We do and some of the chip manufacturers, we're pretty focused on a 52 week lead time. I think I feel Very, very good about how the manufacturing and operations team executed in the Q2 and how they're going about things for the Q3 and for the rest of this year. I would offer that as part of the forecasting process, the guidance setting process, that has become a more Significant input, if you will, into that process and making sure that we've accounted for it in terms of our estimates of any challenges that we may have as we move through the rest of the year.

Speaker 7

Thank you.

Operator

Our next question is from Ben Bollin of Cleveland Research. Sir, you may go

Speaker 2

ahead.

Speaker 8

Ken, historically, When there are periods like this where you see accelerated purchase behavior and a little bit of a run on supply, if you will, Inevitably, there's a bit of a digestion period after the fact as customers learn how to deploy and consume what they just purchased. Could you talk a little bit about how fabric and the broader organization either in sales or the channel is addressing or thinking about that potential risk Into the future?

Speaker 2

Yes, we definitely see more and more customers see the benefit of the fabric February, which cover multiple product integrated automate together. So that's also making the non-forty day grow faster than the 40 day And will be over $1,000,000,000 which will be over $1,000,000,000 this year. So it's a customer By this multiple product, most of them already, like whether they are customer or already test some of the part And then just keep expanding beyond what's the initial purchase there. So we do see the interest guys Stronger and the non FortiGate also keeping grow much faster than the FortiGate, which keeping expanding From whatever the current installation base within the big enterprise. That's also the Gartner forecast, you see that The integration, the consolidation starting kind of more and more important for this big enterprise because to manage multiple products from different vendor It's much higher cost compared to like the platform approach, which can multiple product How about different part of infrastructure, also integrate automate together with the folding fabric approach that we have?

Speaker 3

Ben, it's Keith. And to kind of build on Ken's comment, I think that is the business strategy, right? If you look at our Install base of customers and see how their adoption progresses in terms of the number of fabric products that they add over what period of time, We would certainly expect that to continue on. And then if you look in the current quarter, the new customers that we added, those are largely those are buying firewalls, if you will, And maybe 1 or 2 things, if you will, from the fabric suite. But as we would expect them, yes, I understand they have to digest and install the firewalls, But as we get as they get to know and understand our product and our integration strategy more and more that we'll have the opportunity to come back in and sell them additional products and services as we go forward.

Speaker 5

Thank you.

Operator

And our next Question from Gray Powell of BTIG. You may now ask your question.

Speaker 7

Okay, great. Thanks. Yes. So I'd like to stick with the topic of non FortiGate and Fabric and Cloud and just sort of the strength that you've been seeing there. Within FalconCloud, what are like the biggest product components that have the most momentum?

Speaker 7

And then how should we think about just the sustainability of that demand longer term?

Speaker 2

The non-forty ks, we have almost 30 products, most of them developed internally. And it's So we have not given any individual product because up and down quarterly and also pretty much all contribute Kind of to the growth, we don't see any one or too much kind of offsetting compared with others. So that's Probably maybe sometime later, we can start and get certain things out. But at this stage, we do see It's also dependent on the customer environment, dependent on the sales supporting, like some of them like to have an email working with FortiGate, some is a Web Some is endpoint, some is the network access control or some kind of sandboxing and or It's quite a wide coverage of or kind of even cover all these like the 2,030 product. So that's where it's very difficult to break out and then try to see the trend.

Speaker 2

But we do see the common message really The consolidated, integrate, automate approach definitely has a huge benefit compared to our separate product come from different vendor.

Speaker 7

Got it. That's really helpful. Thank you very much and congratulations on the great results.

Speaker 2

Yes. Thank you.

Operator

And our next question from Adam Tunnell of Raymond James, you may now ask your question.

Speaker 8

Okay. Thank you. I wanted to ask a strategic question to Ken. You had record quarterly free cash flow. So Keith is doing a poor job at managing that more efficient balance sheet you talked about at the Analyst Day.

Speaker 8

But all joking aside, Ken, you've got significant liquidity available both on the balance sheet and can imagine lenders beating down your door. So if you could double click on the key tech areas that you would consider to enhance the value proposition, I would just imagine that SaaS is accelerating, you're the SD WAN leader. For example, some of those secure web gateway players in the private markets are more mature and would that be an area of consideration or any other Key areas that you would consider enhancing the value proposition inorganically? Thank you.

Speaker 2

Yes, we're definitely keeping closely watching all the In the industry and also new technology, all these things, but also we want to keep the innovation, not the culture we have in the last 21 years and also Keith, the organic growth was strong. I probably leave the cash level investment

Speaker 3

Yes, I think for us, I mean, we look at our R and D spending as a source of investment, Not a traditional capital allocation, but we are have historically been a buy versus pardon me, a build versus buy company and that is to We feel strongly about the importance of having the platform to be integrated. You do see us doing tuck in acquisitions. Sometimes they take a little bit longer to bring to market perhaps Because the technologies are things that we want to work with a little bit more before we bring them out. So I don't think that's a surprise. I don't know that that precludes us from doing something larger in the future, but we'll look at those opportunities as they come up.

Speaker 3

The Continuing focus will be finding the opportunities to rebalance the balance sheet with a little bit of the deploying some of the cash that we raised from the debt offering, perhaps to repurchase Some share buyback, if you will. And at the same time also, as we look out for the next 3 to 5 years and we anticipate continued growth, Yes, perhaps a little more investment, if you will, in our facilities footprint.

Speaker 8

That's helpful. Thank you.

Operator

Our next question is from Ervin Liu of Evercore ISI. Sir, you may go ahead.

Speaker 11

Hi, thanks for letting me on. And I would also like to add my congratulations on the great quarter. I had a question on SD WAN. I was wondering if you can perhaps unpack some of the drivers behind the continued momentum here, whether Current hybrid work environment has been a contributor behind the strength. And can

Speaker 9

you help us understand what workers Gradually returning to offices means for you?

Speaker 2

Yes, I mean, good question. SD WAN, we You see very, very strong demand and also huge potential. The approach we have is integrated with advantage compared to some other competitor, whether using the universal CPU or some other approach, which difficult to add any function because limitation for the low cost CPU. So that's where we do believe we will be the leader, the number one leader in SD WAN Space, if not now, definitely will be soon. And SD WAN offer kind of huge advantage My availability, the cost saving compared to the traditional networking protocol MPLS or some other part.

Speaker 2

And also a lot of service provider also starting kind of focus on the SD WAN or 5 gs SIM Android part, which also kind of fit in our kind of Long term bigger picture, we call it secure driven networking, which will be compared to today, all the networking just So the connection and the speed and then the security network, you also need to look at application, the content, the device Behind the user, behind even different kind of location there. So that's where we see how this kind of security function add on top of Networking has huge potential and which SD WAN, the secure SD WAN also just one part of it, but also the secure 5 gs And also internal secure switch and secured WiFi, we do see a lot of potential to keeping using security cover the whole infrastructure.

Operator

Our next question from Taz Koujalgi of Guggenheim Partners. Sir, you may go ahead.

Speaker 5

Hey, guys. Thanks for taking my question. I have a question on the attach of supported subscription to your product this quarter because it looks like you had strong momentum in product, Yes, strong billings momentum also. But it looks like the upside in product didn't lead to maybe sort of similar upside in billings. Was there a difference in product mix, which led to Difference in attach rate between subscription and support this quarter?

Speaker 3

No. I think We track our attach rates and our renewal rates, if you will, within those bands you've seen in the LSA of plus or minus 2%. And I think that we were comfortably inside those bands, so there was nothing unusual in that regard. I think that the services billings in total were probably, And if we go back and check, that's the best quarter that we've had in 4 years. So I think we feel good about both the services and the product performance in the quarter.

Speaker 5

Got it. And just one follow-up. You gave us the mix of billings between FortiGate and non FortiGate. Is that the same kind of mix you have in the product line also? The seventy-thirty roughly, is that the mix of non FortiGate and FortiGate in the product line or is that mix different for product?

Speaker 3

Yes. I don't have that number in front of me, but I don't have a reason. I don't recall them being significantly different when we look at them. And I'm trying to recall what we made in the script just a moment ago in terms of Product

Operator

revenue.

Speaker 3

Yes. I think we've offered FortiGate product revenue growth in the script as well as non FortiGate product growth. And we said they

Speaker 6

were both

Speaker 3

FortiGate was 40% and non FortiGate was over 40%.

Speaker 1

Those are growth rates. We haven't given a breakdown by mix for the 2 For product, we haven't given FortiGate product and non FortiGate product as a mix, we haven't given that.

Speaker 5

Got it. Very helpful. Thanks guys.

Operator

Our next question is from Patrick O'Vaugh of Deutsche Bank. You may go ahead.

Speaker 3

Hey, thank you so much

Speaker 12

for taking my question. I mean, 41% product growth is extremely impressive. I guess, the questions we're fielding from investors around the cyclicality or I guess whether it's secular growth. And so could you just help us understand whether one time benefits Because of recent hacks or because of recent events or post coronavirus that led to this kind of very strong number or are you feeling that The formal market, there are some secular dynamics that we should be aware of.

Speaker 2

Yes. We do see the Lot of products starting to go into the lot of a new part of infrastructure or kind of a new area. And that has also, like Keith mentioned, beside the top five vertical, we do See the other vertical grows faster, much faster than the top 5 verticals, the government service provider, Finance service, education, high-tech, something like that. But also Mike, on infrastructure, we do see like merger deployed on the one side, on the whatever the Smart TV or some other kind of internal infrastructure within data center or even work from home, there's a Quite a broad kind of like a buying pattern compared to before. And that's also we do believe we eventually will drive the additional service because once the product revenue go up and usually service revenue will come in later.

Speaker 2

And also, plus the introduction of the new FortiTrust service, we feel it's also add additional layer of potential service for It's definitely not definitely the secular, like I mentioned earlier, refuse the Changing of the security infrastructure, it's not kind of refresh or replace the traditional firewall, Which also from time to time need to be upgraded because now we get faster and faster, but also expanding into the new infrastructure part and also Kind of a new area, we can see all kind of a growth faster than the traditional medical finance surveys with some other part.

Speaker 3

Yes. As to Ken's comments, I think it was a quarter and it has been for a while now that we just saw a lot of tailwinds. The tailwinds included whether it WAN or OT as an example. The refresh opportunity, if you will, is really an opportunity for us to we view as an opportunity to displace the incumbents as As compared to Fortinet that has 500,000 customers and 70 different firewall models and we even today we announced a new firewall In our press release, it's not as if historically you've seen blips with us in terms of spikes from refresh. But on the flip side, some of the competitors, the legacy players Have a shorter list of customers and a shorter list of products, and maybe you're not doing as well in Gartner Magic Quadrants as we are.

Speaker 3

So we view that as an opportunity. I do think that other tailwinds that came into the quarter, we talked about the verticals, Ken mentioned it again. And also when I look at our customer sizes, whether SMB To always to the Global 2000 did very, very well. I think one thing that stood out for us was the mid enterprise or the commercial part of the business. That came on very, very strong in the quarter as well.

Speaker 3

So I think there was a long list of tailwinds for us that worked in our favor on that product revenue growth

Speaker 2

Yes. Also, the review with the introduction of the new product, the companion core advantage comes from ASIC It's bigger and bigger compared to other competitor, which not only helping Mike, replacing some of their installation base, but also expanding the new area of the internal network in a high speed environment, but also Has a much more function beyond the traditional network security like for our VPN, like we mentioned, whether from the ZeroCloud network access So, some other like SaaS CEO, other part like SD WAN and the 5 gs security, which none of the traditional firewall has. And that's also what additional like sales and on the product and also the future service, which is not refresh Compared to the traditional firewall, which they don't have that function or don't have the company power to keep Additional function of the current performance demanding. So that's why we feel the strategy we have, we leveraged ASIC component power advantage and give us Additional function and additional performance, much lower cost and starting working quite well. Great.

Speaker 12

Thank you so much.

Speaker 2

Thank you.

Operator

Our next question from Paul Liani of Bank of America. You may go ahead.

Speaker 13

Hey, great. Thank you. I want to talk about gross margin. If I'm correct, and if I'm not, it's not going to be the first time, but if I'm correct, your gross margin had gone down about 140 bps sequentially. And I also checked it versus consensus.

Speaker 13

It's lower, 100 bps lower than consensus this quarter, next quarter and 200 bps below consensus For the year, for the guidance. So do I have a mistake in my calculation? Or if not, Can you elaborate on gross margin? Why is it lower sequentially in the guidance?

Speaker 3

Yes. I think what you're seeing, Tal, is The mix shift, right? The product mix shift versus the services mix shift. You can do some pretty simple math in the second quarter and you can get to When you have 41% product revenue growth at 61%, 62% gross margin versus the services that's fairly constant at 23% and 88% gross margin. That 25% swing in gross margin, when you take that back and you look at a 20 point or 25 point over performance in product.

Speaker 3

It works out to be just about 1 point, maybe just a little bit north of 1 point on the gross margin line.

Speaker 2

Yes. Also, you can look on the product gross margin, we actually improved year over year. Even the Cost kind of an increase, but we do improve the product gross margin. And also, we do believe with the Product growth, 41%. We can drive a lot of future growth in the service.

Speaker 2

That's also the reason we enhanced the FortiCare and FortiGuard and same as FortiTrust, which we do believe we're keeping making the future so I mean that the service starting to grow faster Going forward.

Speaker 13

Is there any change in the pricing environment?

Speaker 3

There's no change in the discounting. Discounting for the quarter was neutral for us, if you will. We have taken certain steps as we look forward to Some of the changes in the cost structure that we're seeing from our suppliers and we've taken certain steps in terms of our own pricing going that have not actually hit yet, But they will hit in time for when we actually see those costs in our income statement.

Speaker 13

Can you elaborate on the last point? What does it mean? So do you expect the margins To decline or do you expect to increase prices anticipation?

Speaker 3

I don't expect I do not expect margins to decline, no, Beyond what will happen with the mix shift, if you will, between products and services, right. To the extent we continue to over Over performing the product line the way we just did, it's going to put pressure on the gross margin line. But keep in mind, the operating margin came in right at the high end of the range. So I think we Successfully managed that and it's certainly very consistent with what we foreshadowed earlier in the year where we said within our framework, this was a year in which we would tilt towards growth. We obviously did that putting up 35% billings growth and 41% product growth and at the same time delivering 25% operating margin plus, right?

Speaker 2

Yes. We also did more investment on the infrastructure, which kind of making the service revenue gross Lower a little bit, but also help in the future additional service come in.

Speaker 5

Great. Thank you. Thanks, Tom.

Operator

Our next question is from Itay Kidron of Oppenheimer. You may ask your question.

Speaker 2

Thanks and great results as well guys. Ken, I was hoping you kind of you gave a lot of great color On the backdrop and what you're doing and how you're executing well in the field. But maybe you can tie it up also with the competition discussion. Maybe you can Kind of help us understand what you're seeing from your competitors right now and who do you see is most vulnerable for share losses? It's clear that you're going to continue to gain share in this marketplace for the foreseeable future.

Speaker 2

But who do you see are as the more vulnerable vendors here that are likely Seed to you and others that bring to the table what you can bring to the table. Go ahead. All the competitors are good. And but we just have Some long term strategy investment, which give us more advantage, whether from the ASIC chip, which We started doing 21 years ago, also started doing other part of fabric product, which integrate automate from day 1 Compared to some of our competitors more comfortable acquisition, it makes it more difficult to do the integration and automation and maintenance of the organic growth there. But on the other side, we do see there's certain market shift changing.

Speaker 2

We also want to take the time Like our strategy, we have a product only vendor working with a service provider to see their SaaS need long term build product for them at the same Building some infrastructure, some other things integrate within the Fortiks, Forti OS as the single OS product can Cover both the SaaS, the cross network access or some other part of 5 gs, 51 secondurity, making the product Kind of a more easy for customer to deploy and fit in the big environment, fast environment much, much better. So that past, we will continue to have this kind of a lot of long term strategy and we do see that We'll give us a like a long term benefit going forward. Very good. I tried. Thanks, guys.

Speaker 2

Thank you.

Operator

Speakers, that would be our last question for this call. And I'll turn it back over to Peter Zalcosky. You may go ahead.

Speaker 1

Thank you, Catherine. I'd like to thank everyone for joining the call today. Fortinet will be attending the following investor virtual investor conferences during the Q3. We're doing the Oppenheimer Conference on August 10th And KeyBanc on August 11. Events with presentations will be webcast and those webcast links are going to be up on our website actually.

Speaker 1

They're already up on our website as of now. If you

Operator

This concludes today's conference call. Thank you all for joining. You may now disconnect.

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Earnings Conference Call
Fortinet Q2 2021
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