Interpublic Group of Companies Q3 2022 Earnings Call Transcript

Quartr
Provided by Quartr
November 2, 2022

There are 15 speakers on the call.

Operator

Fortinet Third Quarter Earnings Conference Call. At this time, all participants are in a listen only mode. After the speakers' presentation, there will be a question and answer session. Please be advised that today's conference is being recorded. And without further ado, I will now hand the conference over to your first speaker, Peter Salkowski, Vice President of Investor Relations at Fortinet.

Operator

Peter, please go ahead.

Speaker 1

Thank you, Eric. Good afternoon, everyone. This Pete Tolkowsky, Vice President of Investor Relations at Fortinet. I am pleased to welcome everyone to our call to discuss Fortinet's fiscal results for the Q3 of 2022. Speakers on today's call are Ken Z.

Speaker 1

Fortinet's Founder, Chairman and CEO and Keith Jensen, our Chief Financial Officer. This is a live call that will be available for replay via webcast our Investor Relations website. Ken will begin today's call by providing a high level perspective on our business and then follow our with a review of our financial and operating results the Q3, providing guidance for the Q4 and updating the full year. We'll then open the call for questions. During the Q and A, we ask Before we begin, I'd like to remind everyone that on today's call, we'll be making forward looking statements and these forward looking and in our most recent 10 ks and Form 10 Q for more information.

Speaker 1

All forward looking statements reflect our 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 our GAAP to non GAAP reconciliations are located in our earnings press release and in the presentation that accompanies today's remarks, both of which are posted on the Investor Relations website. Ken and Keith's prepared remarks for earnings call will be posted on the quarterly earnings section of the Investor Relations website immediately following today's call. Lastly, all references to growth are on a year over year basis unless noted 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 standing Q3 2022 results. Revenue for the quarter grew 33%, significantly outpacing the inventory growth rate. We believe that customer recognition of the exceptional value proposition we provided by our high performance for the ASIC technology and Immigrate for the OS operation system is driving our ability to take cybersecurity market share. Porta revenue growth was very strong at 31%, extending our position as a porta revenue leader in the cybersecurity industry. Our product revenue performance reflects the strong demand we have built over the past 18 months across our security solutions, along with the successful execution of our internal team in managing the supply chain challenges.

Speaker 2

Three growth drivers, the heightened threat environment, the convergence of security and networking and at the consolidation of security functionality and vendors together with the opportunity to upsell additional security services to a significant installed base are expected to drive future growth. 1st, the threat landscape, including ransomware, continue to expand and evolve in targeting company of our size, location and industries. To counter the threat landscape, We are implementing our unique universal ZTNA across a wide range of customers, driving triple digit growth for this product and are delivering a comprehensive approach to 0 trust that is consistent for any user anywhere on any device and supporting today's hybrid workforce. 2nd, for years, Fortinet has lead strategy around convergence of networking and We estimate the total addressable market for networking and security will increase from 54,000,000,000 today to self distribute it in 2026. Convergence accelerate digital transformation and substantially reduce operation costs by combining networking modernization with dynamic security that seamlessly spend every part of a network, especially now that many companies are merging SoC and IOC operation together.

Speaker 2

Fortinet is leading the convergence trend with a wide range of technologies, including network firewall segmentation, secure SD WAN, OT security and 5 gs in a single operation system, which can be deployed as hardware, software, cloud and as a service. Fortinet continues to gain secure SD WAN market share as our integrated secure SD WAN solution delivers better security, performance and efficiency over more traditional offerings. In the quarter, SD WAN and OT bookings grow over 45% 75%, respectively, and together accounted for over 25% of total bookings. We believe we can achieve number 1 market share in SD WAN in the next couple of years. Today, we announced the FortiGate 1000x, our latest innovation in convergent networking and security powered by our new MP7 SPU.

Speaker 2

The 1000F delivers 5 to 10 ton higher performance across 6 major network security functions by consuming 80% less power versus competitive solutions. The lower power consumption was a contributing factor in our top 2% ranking in S and P Global Corporate sustainability assessment. Our 3rd growth driver is the consolidation of our vendors and the product functionality With Forti ASIC huge computing power advantage, FortiOS can integrate more security functions than our competitors Together with over 30 key products ranging from endpoint to network to the cloud security, Fortinet provide our customer with easier operation while lower the management costs and the total cost of ownership. Additionally, We are well focused on upselling value added security services to our significant customer base. According to IDC's 2nd quarter unit share data, Fortinet hold the number one market share position for units shipped and 43%, up 210 basis points.

Speaker 2

We expect to reach 50% market share in the next few years. This leadership position and the substantial installed base create attractive economy of scale and an opportunity to upsell additional security services. Before turning the call over to Keith, I would like to thank our employees, customers, partners and suppliers worldwide for their continued support and hard work. Keith?

Speaker 1

All right.

Speaker 3

Thank you, Ken, and good afternoon, everyone. To start with an overview of our strong Q3 performance, revenue of $1,150,000,000 was another quarterly record for Fortinet increasing 33% year over year and 12% sequentially, our highest Q3 sequential growth rate in 11 years. We continue to deliver better than industry average top line growth and generate strong profitability. Our operating margin exceeded guidance at over 28%, driving the adjusted free cash flow margin to 40%. Our history as a public company has evolved around the rule of 40, measured as the combined total of revenue growth and operating margin.

Speaker 3

Impressively, the Q3 total came in at over 60. We continue to see success in our strategy for expanding further into the large enterprise segment. The number of deals over $1,000,000 increased over 80% to 153 deals. The total billings value of deals over $1,000,000 more than doubled driven by a record number of deals over $5,000,000 and G2000 bookings increased over 40%. Our strong third quarter results reflect solid customer demand across both our core and enhanced platform technologies and the exceptional performance of the team in a challenging supply chain environment.

Speaker 3

We believe the investments we've made in building our platform and our go to market engine enables our customers' digital transformation journey. Our platform strategy allows customers to converge networking functionality with security capabilities, while consolidating cybersecurity products, providing security across their entire digital infrastructure, while lowering their operating costs. Recently, The Forrester Wave Enterprise Firewalls report acknowledged the success of our investment strategy, placing Fortinet as a leader for the first time in its history. According to Forrester, Fortinet excels at performance for value and offers a wide array of adjacent services. Long known for its bang for the buck approach to network security, Fortinet has built a flexible and capable platform with its flagship product, the FortiGate firewall.

Speaker 3

Taking a closer look at the income statement, product revenue grew 39%. Product revenue growth for our core and enhanced technology platform products increased 29% and 51% respectively. The product revenue growth rate accelerated over 4 points sequentially, especially impressive given it is our toughest year over year comparison in over 10 years. Service revenue was up 28%, accelerating 3 points sequentially, driven by strong product revenue growth and 7 consecutive quarters of increasing short term deferred revenue growth rates. Support and related service revenue was up 28%, accelerating over 2 points sequentially to 311,000,000 while security subscription service revenue was up 29%, accelerating 4 points sequentially to 370,000,000 Total revenue in the Americas increased 34%, EMEA revenue increased 37%, and APAC posted revenue growth of 23%.

Speaker 3

Total gross margin at 76.2 percent exceeded the high end of our guidance range. Product gross margin of 61% was up 30 basis points year over year. Services gross margin of 86.6% was flat year over year, but up 70 basis points sequentially. Operating margin of 28.3% was up 250 basis points, benefiting from FX and the operating margin leverage that comes with higher revenues. Shifting to billings, Billings of $1,400,000,000 were up 33%, representing the 6th consecutive quarter of billings growth in excess of 30%.

Speaker 3

Core platform billings were up 27% and accounted for 67% of total billings. As shown on Slide 6, Entry level Florida gates posted very strong billings growth with a mix shifting 16 points in their favor, driven by demand and as we expected improved supply. Enhanced platform technology billings were up 45% and accounted for 33% of total billings, a positive mix shift of 3 points. Average contact term was flat year over year at 29 months. Looking at the statement of cash flow summarized on Slides 7 and 8, free cash flow was 395,000,000 Adjusted free cash flow, which excludes real estate investments, was $464,000,000 representing a 40% adjusted free cash flow margin.

Speaker 3

DSOs were down 5 days sequentially, while increasing 12 days year over year to 75 days. Cash taxes were $69,000,000 Capital expenditures were $88,000,000 including $69,000,000 for real estate investments. We repurchased 10,200,000 shares of our common stock for the cost of $500,000,000 bringing the year to date totals to 36,000,000 shares at a total cost of $2,000,000,000 The remaining repurchase authorization totals $530,000,000 Regarding backlog, The backlog at the end of the 3rd quarter was up slightly from the end of the prior quarter, with 48 firewalls accounting for just 1 third of total backlog. We expect 4th quarter ending backlog to be relatively consistent with the 3rd quarter backlog as we are seeing early signs of a transition back more normalized customer buying behaviors. Moving to guidance, the current environment favors a Fortinet style platform that offers integrated solutions and strong security capabilities at an attractive cost of ownership.

Speaker 3

To enhance our ability to capture our share of the large market opportunity, We plan to continue to invest in innovation across our integrated platform offerings. Now, I'd like to review our outlook for the Q4 summarized on Slide 9, which is subject to disclaimers regarding forward looking information that Peter provided at the beginning of the call. And to start, as part of the Q4 guidance setting process, We considered several factors, including the greater macro uncertainty today and with it the increased risk of forecasting the timing of certain larger transactions, The transition to more normalized customer buying behaviors, which means there is less of an emphasis on ordering to get a place online. And for comparison, in the Q4 of 2021, when supply was tighter, backlog increased over $120,000,000 and contributed to 49% bookings growth. And lastly, elevated year over year top line comparisons that includes certain one time items adding a couple of points to service revenue growth and fully cycling the Alexa acquisition.

Speaker 3

In response, we have slightly widened our top line guidance ranges. For the Q4, we expect to again reach the rule of 60. And with that, the key metrics include billings in the range of $1,665,000,000 to $1,720,000,000 which at the midpoint represents growth of 30 percent. Revenue in the range of $1,275,000,000 to 1,315,000,000 which represents growth of 34%. Non GAAP gross margin of 75% to 76%, Non GAAP operating margin of 30% to 31%.

Speaker 3

Non GAAP earnings per share of $0.38 to $0.40 which assumes a share count of between $795,000,000 $805,000,000 We expect capital expenditures of $75,000,000 to 85,000,000 We expect a non GAAP tax rate of 17%. And for the full year, we expect billings and revenue growth to exceed 30% the 2nd consecutive year. Billings in the range of $5,540,000,000 to $5,595,000,000 which at the midpoint represents 33 percent. Revenue in the range of $4,410,000,000 to 4,450,000,000 which represents growth of 33%. Perhaps for context, we should note at the midpoint, these full year billings and revenue growth rates are 3 points higher than the initial growth rates we provided in early February, despite the start of the war in Ukraine in late February, significant increases in interest rates and increasing uncertainty in the macro environment.

Speaker 3

Importantly, full year backlog is expected to be above the February estimate of $350,000,000 Total service revenue in the range of $2,645,000,000 to $2,655,000,000 which represents growth of 27% and apply full year product revenue growth of 42%. Non GAAP gross margin of 75% to 76%, non GAAP operating margin of 26% to 27%, at the midpoint a year over year increase of 30 basis points. And again for context of the midpoint, gross and operating margin expectations are 50 and 100 basis points above the February guide respectively. Non GAAP earnings per share of $1.13 to $1.15 which assumes a share count of between $800,000,000 $810,000,000 We expect full year capital expenditures of $325,000,000 to $335,000,000 We expect our non GAAP tax rate to be 17%. We expect cash taxes to be $265,000,000 Before wrapping up, I'd like to offer some preliminary thoughts on 2023 in our midterm targets, on the heels of a very strong set of growth in 2021 2022.

Speaker 3

We continue to successfully balance growth and profitability, while investing in longer term innovation and go to market initiatives to fuel future growth. The strength of our business model includes this diversification, margins that provide capacity for future investment, and a rich mix of higher margin recurring service revenues. As we saw in the height of the pandemic, the diversification helps mitigate the risk of economic slowdowns. Specifically, in 2020, we delivered operating margins of nearly 27%, adjusted free cash flow margin of over 38% and top line growth of 20%. And during the past 12 months, we have readily exceeded our operating margin target operating margin targets, while increasing our engineering headcount by about 20% and significantly increasing our future sales capacity by over 25%, including a greater than 50% increase in new non tenured salespeople.

Speaker 3

While we will provide more detailed 2023 guidance when we report our 4th quarter results, It's worth noting that service revenue accounts for 60% of total revenue with gross margins hovering above 85%. We see continued service revenue growth driven by 2 years of very strong product revenue growth and 7 consecutive quarters of accelerating short term deferred revenue growth. With a strong business model and a history of being able to execute, we are confident that our momentum will continue and point to our key growth drivers, including strategic investments, the heightened threat environment, the convergence of networking and security and cybersecurity consolidation. Cybersecurity, though not immune to economic slowdowns, is expected to remain a relatively safe harbor. As such, we remain on track to achieve all of our medium term financial targets from our May 2022 Analyst Day, including $10,000,000,000 in billings and $8,000,000,000 in revenue in 2025, each representing a 22% 3 year CAGR in the midpoints of our 2022 guidance.

Speaker 3

The targets also include an average non GAAP operating margin of at least 25% for the 4 years from 2022 2025 and the 2025 adjusted free cash flow margin in the mid to high 30% range. Illustrating our long term focus for balancing growth and profitability, our targets remain committed to the rule of 40 or better. I'll now hand the call back over to Peter to begin the Q and A.

Speaker 1

Thank you, Keith. As a reminder, during the Q and A session, we ask you please limit yourself to one question and one

Operator

And our first question comes from Fatima Boolani at Citi. Fatima, your line is open.

Speaker 4

Thank you. Good afternoon. I appreciate you taking my questions. Keith, this one's for you just with respect to the 4Q guidance and the outlook. Appreciate you kind of breaking down the three principal factors that went into that.

Speaker 4

But I wanted to dig in specifically on the comment you made about normalized Buying behavior as it relates to the backlog build. So I think what I inferred from your comments is that while the backlog It is going to be sequentially up and sort of higher than what you initially pointed out to be maybe $350,000,000 of ending backlog. That's certainly below the $500,000,000 that you were previously telegraphing. So I just wanted to better understand sort of The modulation downward on the backlog there and how the sort of normalized buying behavior contributes to that? And then I'll ask my follow-up.

Speaker 3

Okay. I think when we talk about normalized buying behavior, I think that we certainly saw some enterprise customers in the U. S. During the supply chain challenges. They were placing orders to get in line, to hold their place in line for when inventory is available.

Speaker 3

And I think say a year ago or so that inappropriate behavior when there was a lot of uncertainty around the supply chain and maybe they were planning for what they were going to do in 2022. I think that Somewhat in general now and maybe Ken will talk more about this. I think people are getting the sense that the certainly we are, that the supply chain is a little bit easier to Forecast and it was somewhat easier to manage. I don't mean by any stretch easy, but I do think it's easier. And with that, I think you're starting to see the market drift back towards and I emphasize start to what I would call more traditional buying, which is when they need it, they're placing the order.

Speaker 2

Yes. And also looking at the composition of our backlog, it's only 1 third of that is related to our network security platform 40 ks, more than half related to like a switch and AP, which is a networking equipment, which is a kind of industry Problem in the networking side because the networking device tend to be more exchangeable, more standard driven. So a lot of Customers sometimes double, triple order, try to get ahead of whatever the supply chain issue and also some of them can easily cancel once they got a product. So that's why we feel probably Keeping tracking the backlog may not be the best way to forecast the business and we should be more focused on security, security related, especially driving the future service based on huge 40 ks installation base.

Speaker 4

Thank you. And Keith, just a clarification on the services revenue trajectory and more broadly thinking about next year. So we saw the Reacceleration this quarter in services revenue. So wondering if you can give us a quick update on how the delayed registrations from earlier in the year and transactions from

Speaker 1

earlier in the year are trending

Speaker 4

and how we should think about that from earlier in the year are trending and how we should think about that filtering and flowing into our models for next year? Thank you.

Speaker 3

Yes, I think we've been messaging throughout the quarter at various conferences that and even in the prior quarter that we had a clear expectation that service revenue growth has So we're very pleased to see that. I think there's a number of things that are providing a tailwind into that. Customer registering units is part of that. I think also the price increases making its way first into orders and deferred revenue and now into the income statement. Keeping in mind that we have contracts that sometimes are as long as 5 years, that will give you a How long the tailwind may relate to price increases as we will continue to cycle through renewals at old prices and replace them with new contracts.

Speaker 3

So I think we feel good about the direction of the service revenue and the margins that it provides, together with the fact that it's 60% of our business.

Speaker 5

Our next

Operator

question comes from Saket Kalia at Barclays. Saket, your line is open. Please go ahead.

Speaker 6

Okay, great. Thanks very much for taking my question here. Keith, maybe just to start with you, I'd love to just 0 in on product revenue growth a little bit for this year. Can you just maybe talk about some of the growth drivers for product revenue this year that aren't expected to repeat next year. Again, very helpful detail kind of thinking about total billings for kind of following years.

Speaker 6

But for product, what are some of the one off things that we should be keeping in mind like in ALEXALA, like price adjustments, Just to sort of think about what normalized growth in product might look as we start to think about following the following years?

Speaker 3

Yes, I think Alexa is probably the easiest one to talk about in terms of providing numbers. We've talked about the fact that their revenue stream was probably something on the order of $130,000,000 to $140,000,000 when we acquired them and reminded people that they are a March 31 year end, so their Q4 was a little bit off cycle. I think that its growth is single digits. So I think that probably gives people a good level of expectation. Reminder there that Our interest in Alexa Lab is a lot around IT and some opportunities that we have there to do things more longer term, if you will.

Speaker 3

In terms of Other unique things about Product Room in the quarter, I mean, I think that as the backlog comes into revenue, As we go through the end of 2022 here and certainly into 2023, it's going to provide again a fairly significant tailwind to what the product revenue growth will be in 2023, assuming we get the drawdown in backlog that we may see.

Speaker 2

Yes. Also, we believe the growth driver, especially the converged network and security, We don't think that's a slowdown. We'll be keeping driving the product revenue growth in the next 5 to 10 years. You can see The Secure SD WAN and OT both has a pretty healthy growth and at the same time, we will continue to grow in the next 5 to 10 years in a huge market potential.

Speaker 6

Got it. Got it. Maybe for my follow-up, Really, really for both of you, I'll make a jump all here. I think in Q3, we had operating margins of about 28%. I think the guide for Q4 is for margins a little bit higher.

Speaker 6

When I take that long term guide out to 25% of at least 25%, it feels like you're doing a lot better than that here in the near term. Maybe the question is, how do you sort of think about that balance, right, in terms of growth, maybe moderating or normalizing, as we mentioned, versus sort of that long term margin?

Speaker 2

I think that's where if you look at the certain year history, We as a public company, we always balance the growth and with the margin. So that's where we feel that 25% above is healthy margin, and then we can also give the money to invest in the growth, become a leader in the space. That's where we're continuing to balance. But if the growth slowed down, definitely it will be more helping in the margin. So that's why we keep in saying the rule of 40 Probably in the last few quarters, we kind of even reached the rule of 60 now.

Speaker 2

So that's where also when the growth Slow down and sometimes the service revenue has a higher margin, which can also help in the margin, but we do expect The growth will continue in the next few years with the 3 growth drivers I mentioned and the past additional service revenue to our big installation base. A lot of them not quite enabled to secure the service revenue yet.

Speaker 3

Yes, I would probably certainly agree with Ken and I'll probably just a little more detail on it. Keeping in mind that our We sell in U. S. Dollars. So there's really not a direct FX impact there on the revenue line.

Speaker 3

Obviously, can get into certain countries where the pressure on discounting, if you will, because our exchange rates can be a little more intense. But on the OpEx, because 30% of our business is the U. S. And the rest is international. We do get a tailwind from OpEx from the strength of the U.

Speaker 3

S. Dollar. And I think you're seeing that in Q3 and you're seeing that in Q4. And probably why it's important is that We've talked for a number of years now around and made reference to 25% operating margin. If you go back 4 years ago, 5 years ago, it was probably a target to get 25% operating margin.

Speaker 3

And since then, we've talked about averaging 25% setting a floor at 25%. It has certainly served us well as a way to help other people understand about how we invest in the business, as Ken makes reference to it, As we have funds available over that 25% operating margin, it creates opportunities for some, not necessarily all that you're seeing currently of those margin dollars to be reinvested back in innovation and back into our go to market strategy.

Speaker 6

Got it. Very helpful.

Speaker 1

Thanks.

Operator

And the next question comes from Hamzah Fodderwala at Morgan Stanley. Hamzah, your line is open. Please go ahead.

Speaker 7

Hi, good evening, gents. Thank you for taking my question. Keith, on the backlog, I appreciate, look, Sometimes you have too many metrics that creates too many noise. And on the supply chain front, it seems like It's getting a bit clearer. But could you give us any more granularity on how that backlog and that booking trajectory looked relative to your guidance, which I think when you guided to it, you were saying about 36% growth at the midpoint for bookings.

Speaker 7

So just curious how that shook out in Q3?

Speaker 3

Yes, I think I'll come back to kind of Ken's commentary around backlog, which is really what kind of drives the conversation about bookings. Yes, I think a year ago when we introduced the backlog metric, there was a lot of uncertainty around what the supply chain crisis was going to look like and how it might impact our business. And the purpose of providing the backlog disclosure and the booking disclosure then was to kind of round out and help investors understand more about our business model as we go forward. And as we heard in the question earlier from one of the questions, at the beginning of the year, That kind of swag backlog growth of $350,000,000 in the Q1 and then came back and said in the Q2 maybe it's going to get closer to $500,000,000 for the full year. And now I think we're looking at a number that's going to be less than that, something in the 4s probably seems reasonable for where we're at.

Speaker 3

And I think net net, the message there's 2 messages. So one is, I think we're becoming much more comfortable with our ability to execute in this environment And maybe some easing in the environment itself. And then secondly, I think that it was always our intention, I think we messaged this that these will be short term metrics that we would provide. And I think they've served us and our investors well for an extended period of time, but it's probably time now that we feel that we've gotten a better control on it to bring us more to bring us back in line, if you will, with what our industry competitors are disclosing and not disclosing.

Speaker 7

Makes total sense. Just to follow-up really quickly, I mean, is it fair to say that your bookings growth is still higher And your billings growth, obviously, your backlog grew. So you're still expecting underlying bookings to be higher than 30% this year?

Speaker 3

Yes, we're not going down to the detail of talking specifically about bookings as I just mentioned going forward, no backlog more than what we've given to this point.

Speaker 8

Okay. Thank you.

Operator

Okay. Our next question comes from Rob Owens at Piper Sandler. Rob, your line is open. Please go ahead.

Speaker 9

Great. Good evening. Thanks for Just one from me. Curious with the supply chain getting a little bit easier, how you're thinking about gross margin, both kind of in the short term as well as the medium term? Thanks.

Speaker 2

I think the component and also the cost continuing to go up. So that's where and also we still have a pretty tight inventory to make Most shipments are shipping by air instead of by ocean. So that's where so we're keeping adjust by all these costs and Probably some of them we eat ourselves, some of them we may do some price increase, but we also feel Even some price increase, we continue to have the price advantage compared to competitive investor average with our product. So that's where the margin we feel probably will be more stabilized. And Yes, that's probably the almost supply probably keeping improving.

Speaker 3

Yes, again spot on with that. I have probably a couple a little more granularity. I think if you maybe look at it between product gross margin and services gross margin, the product one is the one that's probably more volatile related to what we're seeing. We've certainly heard commentary that maybe things are easing a little bit with the chip manufacturers, but I will say that there's no indication, any sort of Cost reductions or savings that are coming from either chip manufacturers or the component suppliers. So we'll see how that plays out.

Speaker 3

Our strategy has been, and Ken alluded to this, is that we came into this economic cycle a year ago believing that we had a price performance advantage and that we could raise prices and our target was really to pass along most but not all the price increases, call it plus or minus 1% margin. It's kind of our target every quarter. It doesn't fall that way every quarter because of various variables. And I would imagine that to the extent that prices can remain elevated as we move into 2023. That's kind of the starting point for our pricing strategy into 2023 as well.

Speaker 3

Again, because we have not seen signs that we've lost the price for Performance Advantage. In fact, we continue to win that way. Services are a little bit different. I mean, The largest cost component in services is labor. And if you look back, we're a company that has its annual merit increases in the 1st or second month of the year.

Speaker 3

So you kind of get a rather immediate jolt on the COGS line from those from the compensation increases, which is certainly appropriate. And then you have to grow the service revenue into it. And I think that's part of the conversation about why you saw the reference to sequential margin increases. On the revenue side, it gets fairly complex. Well, maybe not complex, but thinking through how price increases that started about a year ago and kind of hit a quarterly pace, if you will.

Speaker 3

How those price increases We'll make their way first on the balance sheet and deferred revenue and to what extent each item is going to reflect all those price increases and then how it will come off the balance sheet in future periods. So you will get tailwind from the price increases and I would expect that that particular tailwind To continue to for an extended period of time.

Operator

Okay. Our next question, just connecting the line now, It comes from Shaul Eyal at Cowen. Shaul, your line is open. Please go ahead.

Speaker 10

Thank you so much. Good afternoon, guys. Keith, question on APAC. Fox's performance in, I think, like 2 years, what was driving that? And I have a follow-up.

Speaker 3

Yes, I think we've made a leadership change there around the end of June, beginning of July, we had a retirement. And I think that's just kind of the transition of leaders, if you will, as one was exiting into retirement and we brought somebody on. But I think we feel very, very good about in terms of their abilities. And I think the other part of it is that you'll certainly see the lapping effect of Alexa because all of Alexa sitting in APAC, and so you're going to see that now as we roll up on basically the full quarter comparisons, that

Speaker 10

impact. Understood, understood. And on full ticket sales, maybe looking at it from a tier It was slightly more mixed than prior quarters, entry level actually representing most growth versus the mid range and high end. So Any color on that front?

Speaker 2

That's where we see pretty Strong growth related to the SD WAN and OT, which move using the low end unit and same kind of supply chain improvement help a little bit. That's where the we'll be able to shipping more product in the low end side. We still have some backlog in the middle high end, but it's a low end has some improvement by redesigning some of the product and also better supply chain right now.

Speaker 3

Yes. Ken has talked about this in the past, the ability to introduce the new 70F product in the Q2. We were a little bit hamstrung in In the beginning of Q3, even back into Q1 really on the low end. And I think we kind of messaged a bit in our conversations over the last quarter or so that Yes, we expected low end supply availability to really jump, if you will, in the Q3, and we did see that. So It's really more of a supply conversation in some ways as much as it is a demand conversation.

Speaker 10

Thank you for the color. Appreciate it.

Operator

Okay. We're just bringing our next caller live. Okay. Next caller is Srinik Khosari at Robert Baird. Srinik, your line is live.

Operator

Thank you. Hello, Srinik. Brad Zelnick from Deutsche Bank. Brad, your line is live.

Speaker 8

Thank you so much and thank you for taking the questions. Ken, just a big picture question for you to start out with. You mentioned Fortinet's success is in part coming from the industry trend of vendor and product consolidation. Why is Fortinet so well positioned as a platform for consolidation. And how does this inform your product and corporate development roadmap in terms of the need for even more product breadth to compete with other platform competitors out there that keep adding additional functionality.

Speaker 2

I think we have a Few unique advantage, the first from day 1, we developed the 40 ASIC, which have a huge computing power increase compared to using traditional CPU. But also, FortiAC also working side by side with the CPU. So that's The huge computing power advantage comes from Forti ASIC gave us more computing power for the FortiOS to run more function, more security function, including a lot of networking functions. So that advantage is none of our competitor have that. So that's making us keeping driving The market share and also the unit shipment I mentioned, now we're like a 43% of our market share on the unit shipment there.

Speaker 2

So that will be keeping give us long term growth going forward because also on the convergence of The security component power is a must have, is a huge need to address both security and networking function there. 2nd is the FortiOS is well integrated together with more function, leverage and security power. So that's also kind of huge advantage for us compared to some other competitor, whether they have to use like a different blade or different function or they have to load to some like a different box or even to the cloud to address some of the key computing power there. And then third one, we also have about 30 different products, mostly home developed and integrate automated well together. So that's also helping drive, we call the Rider Security Fabric kind of called the mesh network.

Speaker 2

So that's also helping the customer to lower the management cost and total cost of ownership. I think all these three factors will keep in driving Fortinet better position for the consolidation, both on the product functionality and also on different product into a single vendor platform strategy.

Speaker 8

Ken, thank you for that. And it's clearly working very well, your strategy. Maybe Keith, just for you, You've disclosed quite a bit of information so much so that I have a very simple question that I just might have missed. But can you just very clearly Explain for the reduction in the full year billings guidance for that you've given us now The update on with these results? Thanks.

Speaker 3

Yes. I think you're talking about full year Q4 1 and the same at this point. And I would point to the macro environment and what we've seen really in the over the last 90 days in terms of economic activity, if you will. I think when you look at how that manifests for us, somewhat specifically, I think I'm getting a little more cautious in some of the Forecasting of close timing on some of the very large deals. We've been very successful over the last few years.

Speaker 3

You saw some of the numbers about enterprise penetration with our growth in the enterprise. And the deals have actually gotten significantly larger as we've gone forward. And I think it's appropriate in that environment to be a little more cautious on What we expect the close rates to be. The business itself is very healthy. If I look at the end of the spectrum, The small enterprise part of the business, for example, It actually outgrew the other two parts of the business in the last quarter by it took about a point of mix, I think, from the other 2.

Speaker 3

So I feel good about the business, but just a little cautious about the macro environment as we go forward and how to forecast what's coming from the sales team.

Speaker 8

It makes total sense and in line with a lot of other data points that we're all seeing out there. I guess just maybe As you think about what contributes to that, is there it doesn't sound like it's anything competitive, but What are the customers doing? Are they shrinking deal sizes? Are they just taking more time and sweating out their existing assets? Any other color on that would be helpful.

Speaker 8

Thanks.

Speaker 3

Yes, I don't think we're going to see deal sizes getting smaller, For one, because we're moving into the enterprise. If we were more established there and it was just kind of the same routine over and over, The fact that we're growing in the enterprise, and again, you saw the numbers, is going to by itself increase our average deal size. I certainly do feel that there's caution as Corporate America and the rest of the world is probably going through their budgeting cycles right now and looking at what they're planning for No, at the end of 20222023. I think the other aspect of that, and again, I think this is fairly consistent with other comments we probably heard. Yes, I don't think it's a good time to really get in a position of forecasting some sort of significant budget flush in the Q4.

Speaker 3

If it develops, that would be fantastic. But Yes, I think prudence is a little bit appropriate here.

Speaker 8

Makes total sense to me. Thank you so much for taking the questions. Thank

Speaker 1

you.

Operator

Thank you, sir. And next up, we have Srinik Hothari. Srinik from Robert Baird, your line is open. Thank you. Srinik Kothari, Robert Baird, your line is open.

Operator

Okay, we will move on to the next Question, please stand by. Tal Liani at Bank of America. Tal, your line is open.

Speaker 11

Hi. This is Madeleine on for Tal today. Just two quick ones for me and I apologize if this Already been mentioned since we're running between a few earnings right now. But just to be just as Steve is very pointed about it, last Quarter, we heard bookings and bookings just a little bit softer than expected. This quarter, no disclosure on bookings.

Speaker 11

And again, I apologize if this was already mentioned, but Just want to get Keith from your perspective directly why no bookings for this quarter after a weaker quarter of bookings last quarter?

Speaker 3

Yes, we've talked a link to this before you jump on the call and for everybody's benefit, I'll just quickly kind of go through it. I think when we got into this conversation

Speaker 1

a year ago, we felt the backlog, which is really the driver

Speaker 3

of the bookings conversation, A year ago, we felt the backlog, which is really the driver of the booking conversation, was something that was we thought was important to investors understand that we'll be able to track Yes, how we're performing as a business and what they're seeing are the drivers. As we've moved forward, I think that if you fast forward a year later, I think we feel More comfortable now about some of the backlog forecasting and earlier we made reference to backlog may exit the year or something closer to 400 or a little bit north of that. And so with that in mind, I think we're bringing ourselves back into what I would call industry norms where nobody else really discloses this information, but we thought it was appropriate for the first I would also offer one comment about backlog that's important and we get a lot of conversations around cancellation rates. Our cancellation rate has been extremely consistent at about 4% each and every quarter.

Speaker 2

Also the composition of backlog is kind of different now compared to 1 year ago, which is 1 year ago, I have to say majority probably more related to the 40 days Now 40 ks is less than 1 third of the whole backlog. And majority of backlog actually come from the switch and AP Wi Fi, which is also kind of a more industry problem, which is a switch AP more easily. Customer can change in different vendor compared to the security product, they have to design in, they have to it's a very high switching cost. So that's where we feel The backlog sometimes unpredictable and with the majority of our conference reached an AP.

Speaker 11

Got it. Thanks so much. And just one follow-up question there too. I know you guys just mentioned having a little bit of prudence for going into next year and just your guidance. I'm also just wondering on the visibility side, are you seeing less visibility, the Same visibility, can you just talk to the trends that you're seeing there in your own pipeline?

Speaker 3

I think the pipeline visibility is very good and the pipeline growth It's very strong. And I think that one of the things that we did at the end of the prepared remarks was We went back to the mid term guidance numbers that we gave, being a $10,000,000,000 booking company in 2025 $8,000,000 in revenue and Margins of 25% or more, and basically reiterated that. And I think we're doing that, which requires a 22% CAGR from this point forward. We're doing that with the after looking at our pipeline, looking at the strength of our pipeline so that it makes sense to us.

Operator

Okay. Getting ready for our next caller. Our next caller is Keith Bachman at BMO. Keith, your line is open. Please go ahead.

Speaker 5

Many thanks. I also had to, Keith to start with you, I wanted to go back to The billings commentary for Q4, just so on the revenue base is essentially the same and therefore it's a Doctor impact that you're guiding lower. As you mentioned that you're expecting backlog to be less The $500,000,000 and maybe $4,000,000 or $4,000,000 and change. Did some of that backlog, is it actually then flowing into the billings and therefore the billings guide down is even a little bit worse than it actually appears. And any other context you could draw out on where specifically that billings weakness is, is it Europe or what have you, but if you could flush those out, then I had a follow-up for Ken, please.

Speaker 3

Yes, I want to be clear. We are expecting backlog to actually increase from Q3 to Q4, not significantly, but slightly. So, that's okay. Okay.

Speaker 5

So, therefore, none of that backlog then is flowing into that billings in Q4 as anticipated, right?

Speaker 3

Correct. I mean, you're always going to get some existing backlog that flows in the buildings, but you're going to get new backlog. Net net, it's going to be an add in total to it for the year. And I think the and it's a good question about Europe. I don't want to floss over that.

Speaker 3

Europe performed, you saw the revenue numbers And while we don't disclose that, I would say the billings numbers, Europe performed very, very well in the quarter. And their pipeline remains Extremely strong as we go forward. Now we'll see as we get through and get closer to 2023. And I certainly would rather agree that there are certain tailwinds that are appropriate for Europe, but to this point, they've done very, very well.

Speaker 5

Okay. Ken, for you then, it relates to that very directly relates. As we think about Europe and calendar year 'twenty three, the currency is You alluded to is a headwind. So I was just in Europe and customers view that the prices since you price in dollars have actually gone up quite a bit. So is there a risk or how should we think about is there a risk of prices actually needing to come down because of the Dollar based pricing and therefore the significant price increase, if you will, felt by the Europeans.

Speaker 5

Is there a risk that prices need to come specifically down for currency next here and or would you see any risk more broadly, whether it's currency or otherwise, whereby because supply and demand is coming back into balance sometime during CY23 that there is some risk rather than getting price increases that we might be in a situation where prices actually start to move lower.

Speaker 2

I think first about our price policies, really, we when there's a cost increase like components and other, We do like some I mean, take some ourselves and then some other we probably have to pass to the customer partner. But even with like a price increase, we're still leading the industry on the price performance, on the function, on the service. So that's where so far we don't see we lost deal because of pricing and actually we're keeping gaining market share because we have a leading Price performance, especially in a lot of what we call the convergence area and also like SD WAN, OT, all these are very, very fast growing area. So it's all and also we do see a lot of potential to drive additional service because our service charge Probably average about half of our some of our competitor charging, some of the offer free, some of them charge less, some of them sell as a bundle. So we do see a lot of potential growth area in the service, which also have a higher margin.

Speaker 5

Okay. Thank you.

Speaker 2

Thank you.

Operator

Okay. Just pulling up our next caller. And it's Greg Moskowitz from Mizuho. Greg, please go ahead. Your line is open.

Speaker 12

Okay. Thank you for taking the questions. Keith, I know that you had experienced a bit of a pause in the 1st 10 days of June. With that in mind, How was linearity in the Q3 period? Were there any air pockets or anything that you would call out?

Speaker 3

Yes, I don't think we didn't see anything like we saw the good question. We didn't see anything like the 2 week pause or 10 day pause. We saw the 1st part of June in the Q3. I think that When we look at linearity, you can see the DSOs and I think that's a pretty good reflection of where we're at with linearity. It just has not and probably will never be a onethree, onethree, onethree business in terms of linearity.

Speaker 3

You're always going to get about 50% of your business in the Final month of the quarter, but nothing really unusual about the activity there.

Speaker 12

Okay, thanks. And then just as a follow-up, we're getting quite a few questions about that billings guidance for the Q4. And you outlined earlier to in response To Brad's question, the calculus that's sort of going into the Q4 guidance and the Prudence with respect to the possibility for sales cycles to be elongated. I did just want to be clear though on that As it relates to the Q3 period and perhaps even the month of October, are you seeing any changes as it relates to average sales cycles?

Speaker 2

We still have a very strong pipeline, actually stronger than before. At the same time, we build pretty Healthy, strong sales capacity to meet all the demand. Keith mentioned some 10 year like we have about 50% of sales force actually Has a tenure probably not reached the tenure yet, which we believe will become more productive in the next 6 to 12 months, We also are helping drive both the top line, bottom line.

Speaker 3

And just so I don't confuse Ken, because I've already done that. So, 10 year is up about 50% 10 year people. We didn't have given the mix number, but it runs about 30% of the mix. So, it's a significant number of people that we increase are starting new to the organization.

Speaker 12

And that will make sense. I'm just wondering if there were any changes perhaps that you noticed that were might have been macro related affecting sales cycles over the past 3 to 4 months or so. If possible, it would just be very helpful to get a brief commentary on that as well. Thank you.

Speaker 3

I just think that as I said earlier in the conversation, as we started to see some our deal size is getting larger in the enterprise, We're certainly subject to more inspection perhaps than we but the 8 figure deals are certainly much more inspection than the 5 than the 7 figure deals were.

Speaker 12

Okay. Makes sense. Thanks, guys.

Operator

Standby for our next question. Adam Tindle at Raymond James is our next caller. Adam, your line is open. Please go ahead.

Speaker 13

Okay. Thanks. Good afternoon. Keith, I wanted to start to appreciate that you gave a little bit of color on 2023 on services growth acceleration, obviously an exciting catalyst. I think the flip side of that is we're just kind of really unsure how to think about puts and takes to the other line item on product revenue growth.

Speaker 13

Not asking obviously for specific guidance, but I'm thinking about these tough comps. You just had very strong growth on one of Toughest comps that you've ever experienced in Q3. Your exit rate billings guidance is coming down. I think there's worry that the cancellation rates are at 4%, but Could that ultimately increase the supply chain visibility? So a lot of fear on how bad product revenue growth could ultimately be and certainty on services revenue growth.

Speaker 13

So anything you could maybe point us to for a realistic view of how to think about puts and takes to product revenue growth in 2023?

Speaker 3

Yes, kind of covering some old ground here. I don't mean that negatively. One, I would just again, the fact that we reiterated the midterm guidance, which is a 22% CAGR is probably a good indicator of how we think about it. I think that investors and analysts and ourselves are trying to understand The timing of when the backlog is going to reverse and actually go through the income statement and have an impact from product revenue. Yes, it's going to provide when it does happen, I think it'll provide some elevated product revenue numbers as we look forward to it.

Speaker 3

Yes, I don't have another point to that, but I kind of lost my train of thought. I apologize.

Speaker 2

Yes, the growth driver We feel it's not changed like the convergence, like all the consolidation, also elevate like a threat environment. That's how we're keeping driving the product growth. And also the service also, I think the product revenue is the leading indicator of service revenue. So there is a pretty strong product revenue growth in the last 2 or 3 years. We do see the service revenue continue to improve.

Speaker 2

Yes. And I would Come back

Speaker 3

and just talk a little bit about the cancellation rate comment that concern again it has been remarkably consistent at 4%, Not suggesting there's something there that would be a challenge. And certainly, I think the firewall part of that, which is roughly 1 third is probably very specific to us Not really a commodity. There's other metrics that we've provided in the past and we could certainly kind of go through them again. Over 90% to 95% of all backlog is with Existing customers. It's not as if there's people coming off the street and trying to order from us because they're trying to double order or something like that.

Speaker 3

That's just not plausible about it. And of what's in backlog, I think again, over 50% and looking at Peter to nod along, but he agrees with me that has been partially delivered. So it's unlikely they're going to cancel something. So as backlog got older, do we have more concerns about it? I mean, largely aging a little bit.

Speaker 3

We did. But now we're starting to see a bit of a plateau here in terms of what the backlog increases are and certainly some easing around to be on the horizon around the supply chain environment. So While we do watch the cancellation rates very, very closely, we are not seeing indicators of concern there.

Speaker 1

Yes, I think one other If I'm recalling the numbers correctly, I meant to look this back up, but I think the top 20 deals in backlog have come to like 8% of backlog. Yes, that's

Speaker 3

what it was.

Speaker 13

Got it. Maybe I can sneak in a quick follow-up, just to get all the fear out there, because aftermarket move suggests there's a lot of fear. On from a billings basis, you're mixing towards larger deals, which is obviously a good thing for the business, but your average contract term is flat at 29 months. A number of software companies are seeing durations decline, in particular, on those large multiyear deals. How do you think about potentially controlling for this so that Duration doesn't become a headwind to billings growth.

Speaker 13

Thanks.

Speaker 3

Yes, I think as we continue to we've said for Several years and as we continue to expand into the enterprise segment, we expect that that's going to bring with a longer term contract and it has shown that. If you go back A couple of years, I think average contract rates were closer to 24, 25 months, and you're seeing that continued pressure. And I absolutely continue to believe that as we continue to have success expanding the enterprise and that continues to be a larger part of our business, it will continue to put a bit of a tailwind, if you will, on average contract term. I think also SD WAN has shown to clearly be A longer term contract that when customer come to the party. So we're not seeing that.

Speaker 3

I'm happy to see The last few quarters that we've kind of been at that 28%, 29% month, and staying at that level, I was actually a little concerned that it was going to continue to grow and get into the low 30s.

Operator

Okay. We have our last question for the session. Michael Turits at KeyBanc, your line is open, Michael.

Speaker 14

Thanks. So to the extent you can, can you talk about Whether or not it seems realistic for backlog to continue to rise after this quarter or is that the point you think that starts to go down? And at a fundamental level, where do you think we are relative to demand and if you will, a refresh cycle around data centers that may have been neglected during COVID.

Speaker 2

I probably will not using the refresh because I feel in the last like couple of years, there's some change in the network security landscape. So I Probably more using the convergence, especially we see the strong growth from secure SD WAN, OT and also internal segmentation, lot of data center security, which security starting to deploy into the position traditionally and network security is not deployed. So that actually we drove most of the growth from that area. We do get into some big enterprise. They're also looking at how to do the consolidation, like whether networking security working with other part of The infrastructure security there and we also see a very strong growth for our business in the big enterprise there also.

Speaker 2

So that's probably not the time it's already deployed to the new area. And not only the environment is very, very And also a lot of like working from home remotely, but also a lot of new areas drive a lot of New deployment, so that's where probably we're not trying we're not kind of looking at refresh. We're replacing some of the old Not a security device, but it's more in the new area we see will be driving growth for a very long time in the next 5 to 10 years.

Speaker 14

And Keith, on backlog?

Speaker 3

I'm sorry, on backlog? I think the last quarter and then maybe what we're looking at the Q4, it would the inference would be that we're in a bit of a plateau.

Speaker 1

Still going to depend on supply there, which is still

Speaker 2

at any other place. Thanks.

Operator

Okay. At this time, I would like to turn it back to Peter Salkowski, Vice President of Investor Relations for closing remarks. Peter?

Speaker 13

Thank you, Eric. I'd like

Speaker 1

to thank everyone for joining today's call. For that, we'll be attending investor conferences hosted by Barclays, Stifel and Wells

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Earnings Conference Call
Interpublic Group of Companies Q3 2022
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