Fortinet Q1 2023 Earnings Call Transcript

Quartr
Provided by Quartr
May 4, 2023

There are 15 speakers on the call.

Operator

Good day, and thank you for standing by. Welcome to the Fortinet's First Quarter 2023 Earnings Announcement Conference 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 Peter Salkowski.

Operator

Go ahead.

Speaker 1

Thank you, Chris. Good afternoon, everyone. This is Peter Salkowski, Senior Vice President of Finance and Investor Relations at Fortinet. I'm pleased to welcome everyone to our call to discuss Fortinet's financial results for the Q1 of 2023. 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 for replay via webcast on our Investor Relations website. Ken will begin the call today providing a high level perspective on our business. Keith will then review our financial and operating results for the Q1 of 2023 before providing guidance for the Q2 of 2023 and updating the full year. We'll then open the call for questions. Before we begin, I'd like to remind everyone that on today's call, we will be making forward looking statements.

Speaker 1

And these forward looking statements are subject to risks and uncertainties, which could cause actual results to differ materially from those projected. Please report 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 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 today are non GAAP unless stated otherwise. Our GAAP results and GAAP to non GAAP reconciliations are located in the earnings press release and in the presentation that accompanies today's remarks, both of which are posted on the Investor Relations website.

Speaker 1

Ken and Keith's prepared remarks for today's earnings call will be posted on the quarterly earnings section of our Investor Relations website immediately following today's call. Lastly, all references to growth are on a year over year basis unless noted otherwise. I'll 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 Q1 2023 results. For the Q1, revenue growth was 32% due to strong growth in both product and service revenue. With 75% product revenue growth, we continue to gain market share while being a leading product revenue company in the cybersecurity industry. This strong product revenue growth will help drive future service revenue growth. Quarterly service revenue grew over 30% for the first time in 6 years.

Speaker 2

We believe we have a significant opportunity to upsell value added secure service to a large installed base. In the Q1, SD WAN and OT bookings together continued to account for over 25% of total bookings, and our goal is to become the number 1 in network firewall, Secure SD WAN and OT security market over the next couple of years. Fortinet is leading the trend of network and security convergence and the cybersecurity consolidation. Gartner expects that by the year 2,030, the secure networking market will be larger than traditional networking. Traditional networking lacks awareness and control of content, applications, users, Device and the location and is still using the same network protocol that was developed 50 years ago.

Speaker 2

Fortinet Secure networking solution has expanded from next generation firewall to SD WAN, SD Branch, 5 gs, Internal segmentation, ET and A and Universal SaaS and we believe the secure networking market can achieve double digit growth annually for the foreseeable future. In today's environment, Our Vision are looking to consolidate their multiple security vendors and functions that are deployed across their expanding attack surface to lower their total cost of ownership and management cost by improving visibility and automating real time threat detection and response. Fortinet's latest release of FortiOS 7.4 together with the FortiOS P5 ASIC These the industry in better integration and automation as well as the faster acceleration will lower total cost ownership. SmootyOS enable our nation to deploy the Fortinet security fabric to every edge, allowing security to dynamically scale and adopt as network evolves. Last month, we announced universal SASE, which is supporting hybrid infrastructure and enabled the same networking and security features that are available in our plans to be delivered as a service All within a single console.

Speaker 2

Many of our service provider partners are collaborating with us on these offerings. Also, we announced enhancement to several of our Fortinet Security Fabric solutions, including endpoint security, Cloud Security, SOC and SOAR. As networking and security continue to converge and customers looking to consolidate vendors and point product, we believe we are well positioned to achieve our 2025 building target of 10,000,000,000 while generating an annual non GAAP operation margin of at least 25% for each of the next 3 years. Before attending the call over to Keith, I would like to thank our employees, customers, Partners supplies worldwide for their continued support and hard work. Please?

Speaker 3

Thank you, Ken, and good afternoon, everyone. Let's start with the key highlights from our strong Q1 performance. Our strong Q1 results reflect the continued demand for our broad portfolio of cybersecurity and networking solutions and the demand for consolidation and convergence that is delivered by our integrated single platform strategy. Total revenue growth of 32% was led by strong product revenue growth and service revenue growth accelerating to over 30%. Billings increased 30%, our 8th consecutive quarter of at least 30% billings growth.

Speaker 3

Secure SD WAN and OT bookings once again accounted for over 25% of total bookings. Our strong top line results reflect continued by solutions, geographies, customer segments and industry verticals. We continue to deliver balanced growth and profitability with better than industry average top line growth and strong profitability despite the continued economic uncertainty. The Q1 operating margin of 26.5 percent represents the highest Q1 operating margin in our 14 year history as a publicly traded company. Free cash flow of $647,000,000 representing a margin of 51%, is up 23 percentage points.

Speaker 3

Both the quarterly free cash flow and free cash flow margin are Fortinet post IPO records. Last month, we hosted nearly 3,000 customers and partners at our very successful Accelerate conference, I'd like to recap 3 key themes. 1, the expanding firewall deployments environment 2, convergence and 3, consolidation. So starting first, today's rapidly evolving threat landscape and connectivity demands a comprehensive approach to firewalls and network security, including a combination of hardware, virtualized software and security services. In fact, Gartner anticipates that by 2026, more than 60% of organizations will have more than one type of firewall deployment, which will prompt adoption of hybrid mesh firewalls.

Speaker 3

Fortinet is well positioned to capitalize on this expansion of firewall deployments and form factors as we've been delivering hybrid mesh firewalls for years on a single operating system. 2nd, the company was founded 20 years ago on the belief that the convergence of security and networking will become an industry standard. Gartner shares this belief noting that expect to size the secured networking market to overtake the traditional networking market by 2,030. We believe secured networking at scale works most effectively on ASIC technology. Since its inception, Fortinet has been deploying developing proprietary ASIC technologies to build application specific solutions to support convergence as traditional CPU based solutions are less efficient at supporting both networking and security.

Speaker 3

3rd, vendor and product functionality consolidation strategies continue to become more commonplace. Looking to Gartner here again, we note 75% of organizations are pursuing a cybersecurity vendor consolidation strategy in 2022, up from 29% in 2020. Our integrated FortiOS platform allows customers to converge networking functionality with security capabilities, while consolidating cybersecurity products and functionality. With Forti ASIC's significant computing power advantage, FortiOS can consolidate more security functions and solutions while maintaining our performance and cost advantage. Specifically, FortiOS supports many security applications, including network firewall, SD WAN, SASE, 5 gs, Wi Fi security, ZTNA, VPN and SSL with a variety of use cases for each For example, firewall use cases include data center, branches, edges, virtual, cloud native, Micro segmentation, both east west and north south and firewall as a service.

Speaker 3

Our convergence and consolidation strategy provides security across our customers' entire digital infrastructure while lowering their operating costs. All right, now let's take a closer look at the Q1. Billings grew 30 percent to $1,500,000,000 driven by enhanced platform technology solutions. In terms of industry verticals, Government and Financial Services topped the list as a percentage of total billings with Financial Services up over 40%. Construction, media and utilities were all up at least 50%.

Speaker 3

Those growth benefited from better than expected backlog contribution. While the backlog cancellation rate increased quarter over quarter, it was lower than we had forecasted in our model. We continue to believe there's an elevated cancellation risk in future periods for networking equipment backlog. Bookings grew double digits in the quarter, off a challenging comparison to 50% growth in the Q1 of last year. We continue to see success with our strategy to expand further into the large enterprise segment with a number of deals over $1,000,000 increasing 38% to 124 deals and billings on these deals increasing 50%.

Speaker 3

One of these deals was an 8 figure expansion and upsell opportunity at a Fortune 50 retailer. The retailer was looking to replace their firewall point solutions with a more holistic cybersecurity solution. After purchasing FortiManager and FortiAnalyzer in the Q4 of last year, this customer selected FortiGate VMs for a very competitive effort through very competitive process for their 2,000 store locations as part of our new FortiFlex program. FortiFlex is a new points based consumption program supporting hybrid mesh firewall deployments as well as a variety of other security solutions. The customer selected Forinet due to the substantial value offered by our unified platform and the significant technical requirements.

Speaker 3

In the Q1, we added approximately 6,100 new logos, reflecting the support of our channel partners through their investments and the investments we've made in them. Average contract term was flat year over year at 27 months and down 1 month quarter over quarter. Turning now to revenue. Total revenue grew 32 percent to $1,260,000,000 driven by strong demand for core and enhanced platform Technologies increasing 23% 50% respectively. Product revenue of $501,000,000 increased 35% despite the very difficult comparison to last year's Q1 of 54% with its very strong contribution from acquisitions.

Speaker 3

Product revenue growth was driven by strong growth in enhanced platform technologies, improving supply chain dynamics and our earlier pricing actions. Service revenue was up over 30 percent to $762,000,000 the highest growth rate in services since 2016. The average number of days between when the customer purchases and subsequently activates a security service contract declined slightly sequentially and remained elevated on a year over year basis. Service revenue growth was closely aligned with our short term deferred revenue growth rate in recent periods. Short term deferred revenue growth was over 30% for the 4th consecutive quarter.

Speaker 3

Total gross margin of 76.3% was up 1 190 basis points, including a 440 basis point increase in product gross margin to 61.8%. Product gross margin benefited from earlier pricing actions, improved discounting and easing cost pressures. Service gross margin of 85.9 percent picked up 70 basis points as price increases offset increased investments in data centers and points of presence or POPs. Operating margin of 26.5% was up 4.50 basis points due to the strong gross margin performance of foreign exchange benefit and revenue growth that was 10 points higher than our 22% headcount growth. As previously noted, 26.5 percent is our highest ever first quarter operating margin as a public company.

Speaker 3

Looking at the statement of cash flow summarized on Slide 78. Free cash flow was a quarterly 4 net record at $647,000,000 and benefited from elevated receivables in the Q4 of last year and the subsequent cash collections as well as the record setting operating margin and the timing of CapEx projects. Adjusted free cash flow, which excludes the real estate investments, was $662,000,000 representing a 52% adjusted free cash margin and our highest margin since our 2,009 IPO. We've come to expect some quarterly variances in our free cash flow results with the Q1 often stronger due to the seasonally strong 4th quarter billings. Capital expenditures were $30,000,000 including $15,000,000 of real estate investments.

Speaker 3

This was lower than expected due to the timing of real estate activities. Cash taxes were $21,000,000 The Board increased the company's share repurchase authorization by $1,000,000,000 and the total available share buyback authorization is now $1,500,000,000 for repurchases through February 2024. Looking forward, we are excited about the growth drivers that we've discussed previously as well as our new single vendor Universal SaaS offering. Our universal SaaS offering delivers a comprehensive solution that extends the convergence of networking and security from the Edge to remote users, while helping teams drive operational efficiency and reducing complexity and costs by consolidating vendors. In fact, Gartner predicts that by 2025, 1 third of new Sassy deployments will be based on a single vendor Sassy offering, up from 10% in 2022.

Speaker 3

As we bring Universal Sassy to market, we expect to make various investments including increasing our POPs. Our guidance reflects the impact of these investments to both our gross margin and capital expenditure estimates. Moving to guidance. I'd like to review our outlook for the Q2 and full year summarized on slides 1011,

Operator

which is subject to the

Speaker 3

disclaimers regarding forward looking information that Peter provided at the beginning of the call. For the Q2, we expect billings in the range of $1,560,100,000 to 1,600,000,000 which at the midpoint represents growth of 21 percent. Revenue in the range of 1,280,000,000 to $1,320,000,000 which at the midpoint represents growth of 26 percent non GAAP gross margin of 75.5 percent to 76.5 percent non GAAP operating margin of 24.5 percent to 25.5 percent Non GAAP earnings per share of $0.33 to $0.35 which assumes a share count of between $790,000,000 800,000,000 Capital expenditures of $80,000,000 to $110,000,000 a non GAAP tax rate of 17 percent Cash taxes are $35,000,000 which is lower than our prior expectation as the deadline for certain tax payments has been extended to the 4th quarter. The 2nd quarter guidance assumes backlog decreases during the quarter. For the full year, we expect Billings in the range of $6,750,000,000 to $6,810,000,000 which at the midpoint represents growth of 21%.

Speaker 3

This guidance assumes a low single digit impact of billings growth from backlog. Revenue in the range of 5,425,000,000 to $5,405,000,000 which is a midpoint reference as growth of 23.5 percent. Service revenue in the range of $3,370,000,000 to $3,400,000,000 which at the midpoint represents growth of 28%. The service revenue guidance implies product revenue growth of 16%. Non GAAP gross margin is 75% to 76%, Non GAAP operating margin of 25% to 26 percent, non GAAP earnings per share of $1.44 to 1 0.48 which assumes a share count of between $795,000,000 $805,000,000 capital expenditures of $400,000,000 to $450,000,000 due to the continued cloud, data center and facilities investments.

Speaker 3

Non GAAP tax rate of 17%, cash taxes of 390,000,000 with approximately $300,000,000 in the 4th quarter. The full year estimates assume backlog returns to historical levels later this year. As we wrap up the prepared remarks, maybe one additional observation. Over many years, the Fortinet team and its partners has offered very solid and consistent level execution across a wide range of economic cycles and other challenges. Like many others, we see a level of economic uncertainty in front of us, and we look forward to this possible challenge in delivering on our goals.

Speaker 3

I'll now hand the call back over to Peter to begin the Q and A.

Speaker 1

Thank you. As a reminder, during the Q and A session, we ask that you please limit yourself to one question And one follow-up question to allow others to participate. Chris, please open the call for questions.

Operator

Thank you. At this time, we'll conduct a question and answer Please standby while we compile the Q and A roster. Our first question comes from Brian Essex from JPMorgan. Your line is open.

Speaker 4

Hi, good afternoon. Thank you for taking the question and congrats on a nice quarter, particularly in a tough macro. Maybe, Steve, for you, nice acceleration in services revenue this quarter. And I know Ken talked about More effectively selling value added services, secure services into your installed base. How much was Due to that better tax rate of secure services versus changes in registration policy or pricing increases in the quarter?

Speaker 3

Yes. Let me great question, Brian. And I think when we peel back the onion and look back, we saw in FortiGuard, which is the security services part of the business, And you'll see this in our SEC filings next week. Growth was 35% for FortiGuard. So we started looking more deeply at that.

Speaker 3

And to Ken's point, what we saw there Where areas like SaaS products and offerings that are attached to existing customers, certain cloud offerings, what we call pay as you go, if you will, are attached to it as well. And I would describe those as being a significant driver to the growth. I think the price benefits will probably take the number 2 slot And then the number 3 slot would be some changes in the registration behavior. By that, I mean, the customer did register a little bit faster in the Q1, but that lag or that registration policy change that we implemented in the Q1, I would specific call out as not really having an impact in the Q1 nor did we really expect 1. So kind of in order, I think it was selling into the installed base, Price increases and then some light improvements in the registration behavior.

Speaker 2

Yes. Also with the new 40 or 7.4, we started launching And we started to have a more function, which can also enable much more new service going forward for both the current customer installation base and also for new customers.

Speaker 4

Got it. That's helpful. And maybe as a follow-up, Keith, I think you commented on lower than expected cancellation rate. I know the question will be asked. Impact on billings from backlog And what some of your assumptions are, particularly given what you see in the macro?

Speaker 4

I know you talked about you expect to be at normalized rates for backlog by the end of the year, but maybe if you can Contextualize or quantify that to the extent that you're able to.

Speaker 3

Yes, I think in the guidance, particularly as we look at the full year, it's kind of difficult to figure out exactly which quarter some of that backlog is going to end up in or be canceled. But for the full year, I think we talked about low single digits growth that would be coming from the backlog. I do think that the risk of cancellations increases as the year progresses. And by that, I mean, Yes. If a customer has only been in backlog for a week or a month or something like that, there seems somewhat less probability that they're going to cancel.

Speaker 3

But the longer it takes to deliver on that backlog, I think cancellation risk continues to increase.

Speaker 2

Also, a point is really, you mentioned Go back normal end of the year. We say it's later this year. It could be mid or could be towards the end. But in Q1, I'd say the operation team did a great job to reduce the backlog, which also helping secure more customer and lower some cancellation rate.

Speaker 4

Got it. Very helpful. Thank you both very much.

Operator

Thank you. One moment for the next question. This question comes from the line of Gabriela Borges with Goldman Sachs. Your line is open.

Speaker 5

Good afternoon. Thank you. I have this for Ken or for Keith. It's a follow-up question on forecasting, Which is we've heard so much noise in the industry around supply chain and COVID catalyzed product cycles. How do you all think about True demand and potentially plan around the risk of demand going faster than expected given you've had a very strong couple of years?

Speaker 5

Thank you.

Speaker 2

I think probably some of that more refer to the traditional network We secured some enterprise deployment enterprise, but we do see that our solution has a much broader use case And also expand much bigger market opportunities in the traditional enterprise firewall. And also the SD WAN OT is also see very strong growth continue to helping drive both the new And also expanding the current and recent customer. Also in the SMB space, it's relatively greenfield. We also see pretty healthy Faster growth, probably even faster than the traditional enterprise, which is mobile placement.

Speaker 1

I think all this I

Speaker 2

see Contributing to pretty healthy, keep it saying, double digit growth in the future for the whole network security space.

Speaker 5

Yes, that makes sense. Thank you. And Ken, the follow-up is for you, which is, as you start to execute more On the convergence of selling into the networking budget or the convergence of networking plus security, when you look at the classic networking competitors, How do you think about the barrier or the limitation for classic networking vendors to get more into security and become more competitive In the convergence of the time.

Speaker 2

I could say from the product architecture, It's very different because security needs much more complete and power and to handle a lot of unstructured data, which the traditional networking company probably more based on some structured data handle some fixed next protocol And much less company power needed to process data compared to the network security. So that's where And also, we would have to implement the function and new function come up every year in the software first and then keeping enhancing and improving the performance leverage ASICs. That's also we don't see networking company doing some of that. They probably may be slow on where to come up with a new function for the security Space, all kind of have a different architecture to very supporting the secure computing needed for network security. So that's we so far we have not seen the traditional networking company already come close.

Speaker 2

They did some acquisition, but so far, I don't see they've already come up too much since to meet a new demand from customer, both on the function and also on The surveys on the infrastructure change.

Speaker 5

Thanks for the detail. Congrats, Nicolas.

Speaker 2

Thank you.

Operator

Thank you. One moment for the next question. The next question comes from the line of Fatima Boolani of Citi. Your line is open.

Speaker 6

Thank you. Good afternoon. I appreciate you taking my questions. Ken, just a technology vision question for you. You are very and the team is very bullish on the Sassy opportunity that was very apparent at the Accelerate conference as well.

Speaker 6

But I'm curious as to why you're taking the effort to build out data centers and points of presence To deliver your universal SaaS fee strategy versus maybe some of your peers and competitors who are maybe relying on 3rd Hardee providers and hyperscalers. And then I have a

Speaker 5

quick follow-up for Keith, please.

Speaker 2

Yes. First of all, Sassy Kind of a vision a little bit different than some of our competitor. We do believe it needs to be universal, need to be more broadly deployed And also more leverage, a lot of service provider infrastructure. It's kind of a hybrid environment instead of a cloud only SaaS solution. And we do keep expanding some of our path because there's definitely there's some user, like whether It depends on work from home or some other cloud, SaaS, to secure some of their traffic there.

Speaker 2

But on other side, there's a Huge base of customer need to use SaaS, our kind of service model, leverage both service provider of their current infrastructure And even on-site appliance. And so that's where in certain point, we also see our FortiSwitch and FortiAPs are And how our agent helping forward the traffic for the FortiGate to process all this SASE traffic there. So that's the reason we kind of put Sachi in a single OS, both on the networking side of function like SD WAN, 5 gs or other Past the security like a CASB, DLP, all these firewall service, all these things. So that's where we have a more Integrated, more broadly distributed and leverage whatever the hyper infrastructure strategy solution there. That's also the reason we continue to build some of the POP.

Speaker 2

It's a little bit different than some other large certain cloud provider Because we do see the car provider potentially also can be the service provider to offer Sassy and also from the ROI Point of view, even have a little bit more investment from the beginning to build some pulp ourselves, but long term will be more profit model. So we'll have a better margin. So we will take some time to make sure we build a healthy ecosystem, both with our partner and also with the investment for long term benefit.

Speaker 6

I appreciate that detail, Ken. Keith, just quickly for you, kind of a tactical question on the billings outlook. You're raising the full year by less And half of the beat and the raise when I think about the first half. And so maybe from a bottom up perspective, can you walk us through what sort of Underpinning that conservatism, I can appreciate the macro is jittery, but if you can kind of give us some more Tangible considerations we're thinking about in terms of a bottom up perspective on getting to that billing guide for the full year. Thank you.

Speaker 3

Yes. I would say, one, just kind of as a general thought, I think raising it to some extent, I think probably gives you a little bit of a message that we feel good about our strategy and the execution that novel that we can bring to the market. But more specifically and more tactically, As we look through the second half of the year, there's probably a little more rigor and effort, if you will, in trying to look at what we see coming in the second half And I would give you that probably the two headlines that we're looking at. 1 is we're still very, very pleased with the pipeline and the pipeline continues to growth, continues to be Well above anything that we're talking about growth rates for the company for the full year. But I think the nuance that and maybe it's not even nuance really that's come into play now is more about close rates.

Speaker 3

It's not just as simple as taking your pipeline, assuming you're going to have close rates That we're at the same level they were in prior periods. And that when we use the term close rate, it's not a suggestion that deals are getting lost, but this Continual cycle that we seem to be in where some of the larger enterprise deals in particular are taking longer. They're pushing out a lot of pushes. It's not that there's been an increase in losses, but the continual push. And so with that in mind, I think a fair amount of attention looking at the full year guidance on what we really think Those rates may be for the second half of this year.

Speaker 5

Thank you.

Operator

This question comes from the line of Saket Kalia of Barclays. Your line is open.

Speaker 7

Okay, great. Hey, good afternoon, everyone. Thanks for taking my questions here. Ken, maybe just to start with you, Great to see ForwardNet sell the whole breadth of the platform, particularly within the enterprise. Could you just maybe talk about anything that you can do to make it easier for customers to consolidate spending with Fortinet, whether that's And enterprise license agreement or any other thing that sort of makes it easier to combine, consolidate those vendors, which was a theme I think was talked earlier?

Speaker 2

We definitely see some healthy growth of our enterprise agreement and also we're working closely with our Channel partner with our service provider also leverage their connection, their resource a healthy ecosystem to grow together. But I also see the From enterprise level, they also see the benefit of consolidation definitely and also not just consolidate some of the security product, but also on the We do see that we call it enhanced technology side also has pretty healthy growth. Yes, the sales force also you can see the number of 1,000,000 deal, both on the number and also on the dollar wise Has a pretty healthy growth, continue to accelerate and grow beyond the total building growth. So that's a pretty healthy A trend we see going forward to helping customer consolidate.

Speaker 3

Yes. And Saket, maybe just this is Keith. Just to go along a little deeper on what Ken is talking about there and I'll give Maybe four quick examples. So enterprise agreements, something that we've been doing now for probably a couple of years. We track those as a in some ways as a different line of business in terms of the growth rates.

Speaker 3

And particularly as we move into the enterprise, I think it's been very important to be there and we've been very successful with it. I think another illustration of trying to make it easier for customers was the example of the large retailer we gave call today and we talked about the points program, right, which is an easier way I think sometimes for them to get on board and consume more of the products. And I think also then when we sell, making sure that our salespeople are well trained on the value proposition that we're offering, Not just on the cost of the appliance or the throughput of the performance, but also what it means to the customers' management costs and overhead costs as well. So I think those types of things are all going into play here to support what Ken is talking about, about making it easier for customers to consume our products.

Speaker 7

Got it. That's super helpful. Keith, maybe for my follow-up for you, great to see that 30% Growth and acceleration in services revenue. Maybe the question is, how do you think about what portion Of your existing subscription base hasn't seen that cumulative impact of the price increases you've done yet, Right. Like clearly the price increases on product have been fully baked, but how much of the base or maybe how long will it take for the subscription base to fully realize that pricing as well?

Speaker 3

Yes, great question. And I think it didn't really look at the numbers closely this quarter, but did last quarter. A couple of things to keep in mind. The average contract term, call it 27 months. If all the contracts are 27 months, you could do that math.

Speaker 3

But they're not Yes, summer 1 summer 3 year contracts in terms of the renewals that are coming through. So probably 1 5 year contracts. Sorry, Peter, thank you for that. So it does have a long tail. And again, I refer you back to how many quarters or how a few years that we talked about Seeing the uplift that came when we converted to 20 fourseven support from 8x5, that was something that continued to provide a benefit for several years.

Speaker 3

I think the tail gets smaller, obviously, as you go further out. I think the majority of what's of the existing contracts, More than 50% are under the new pricing.

Speaker 7

Very helpful. Thanks guys.

Operator

The next question comes from the line of shawl Ihle of TD Cowen. Your line is open.

Speaker 8

Thank you. Good afternoon. Congrats on results and guidance in tough macro. Keith, maybe starting with you. Can you comment can you provide us with some color about the financial vertical performance this quarter?

Speaker 3

Yes, it's well, financial services have always been one of our I should say always, but for a long time they've been in the top 3. And it can be a bit Future famine, there were some very large deals in the quarter, but I don't think there was anything that was number 2 in this particular quarter. Thank you, Peter. I don't think there are any really large deals that drove that number. I think it was we saw growth and success not only in the U.

Speaker 3

S, but also internationally, particularly in Europe. And so I think it was a strong quarter for us in that area.

Speaker 8

Got it. From a product mix perspective. So the entry level performed the best versus the high end. Is that just a mix or a macro And also, did you have any 8 digit wins this quarter?

Speaker 3

So we talked about yes, we did. Okay.

Operator

I think

Speaker 3

think we talked about 1 in the script just a moment ago. And I think we commented that was an 8 figure deal, if I'm not mistaken, right, without giving a specific number. Yes. And I don't recall if there was a second 8 figure deal, there was a second.

Speaker 2

Yes. Also, our SMB had pretty Healthy growth, like I said, the SMBs are more greenfield for the network security. We do see more and more SMBs need network security to protect Their business especially comes from some other Western Wear Tech. On enterprise, because it's kind of more replacement And also a lot of enterprise kind of maybe the business environment, we Some of the hardware more dependent on the service. So that's impact some of the high end and also the other benefit for some of The low end, middle range is really most I'd say most IC WAN and some of the OT deployment Maybe more towards the low and middle range.

Speaker 8

Got it. Thank you. Appreciate it. Well done.

Operator

Thank you. Thank you. One moment for the next question. This question comes from Rob Owens of Piper Sandler. Your line is

Speaker 9

open. Thank you very much and good afternoon. Thanks for taking my question. I wanted to start around OpEx The corollary operating margin and very strong Q1 here, I think you mentioned it was the strongest Q1 that you've had since you're public. If I go back through results since you've been public, Q1 has never really been the high watermark from an operating margin standpoint.

Speaker 9

So walk me through your thought process as the rest of this year plays out? Was there some aberration in Q1 that really helped drive that or just a lot of conservatism as we look ahead?

Speaker 3

Yes. I think that we called out 3 things and maybe focusing on 2. 1, we had a very strong gross margin in the quarter, and I'll elaborate on that in a moment. And then also FX continues to provide Tailwind. More commentary about the gross margin, particularly the product gross margin.

Speaker 3

As we move through the supply chain challenges and then into inflation, etcetera, over the last Couple of years, I think we've talked publicly that our goal was to try and keep the product gross margin around 61% or so. The Q4 came in obviously very low. We did not anticipate that we'd be able to time our price increases and the cost increases Perfectly. So they went through the income statement in the same quarter, so to speak. And with that, I think you saw a little bit of pressure in the Q4 and then you saw it kind of revert In the Q1.

Speaker 3

I think longer term, we also look at product gross margin as an opportunity sometimes for us to continue to invest in growth. And I think we've The Q1 gross margin, certainly well above that band that I just talked about. And with that in mind, as we start to see some of the costs moving out The equation, when we introduced new products, I think we'll be looking at that in terms of is there an opportunity there to make certain investments Growth while maintaining the margin commitments that we've talked about.

Speaker 9

Great. And then as a follow-up, did want to touch on the OT business and the strength you're seeing there. Can you talk a little bit from a go to market standpoint and some of the channel programs because it does seem like there's some new large channel partners out there that are very excited about the opportunity? Thanks.

Speaker 3

Yes. I think OT, we do look at I mean, you're always trying to organize your sales force around verticals, geographies or what have you. And I think when we started to see the opportunity in OT several years ago, Patrice and Ken made a decision To start separating that out and having really a separate sales function and some people that specialize in that. I do think that we probably got Some first mover advantages by doing that, particularly as we look at Europe and then quickly fall thereafter by the U. S.

Speaker 3

And yes, there are some large names that are in that space that are providing technology, not security technology, but technologies in the OT space that have been very receptive, if you will, to conversations and opportunities to meet with us.

Operator

Thank you very much. One moment for our next question. The next question comes from Adam Borg of Stifel. Your line is open.

Speaker 10

Awesome. Thanks so much for taking the questions. Just for Ken or Keith, obviously, it's great to see the strong collections and the record free cash flow. And you also talked about contract terms being consistent year over year. I was just curious though, just given the tougher macro, are you seeing any pushback by customers around Willingness to pay upfront?

Speaker 10

And then I have a follow-up.

Speaker 3

Yes. Well, first of all, I want to revel on the $600,000,000 free cash flow, which we're doing For some of those quarters, but I kind of let people know that a lot of the things fell our way in the quarter. There's always the conversation and part of the sales cycle, if you will. Yes. The customers got a 1 year, 3 year, 5 year deal.

Speaker 3

And certainly in a rising in an environment where interest rates have gone up, I think there A lot more many more conversations that exist around payment terms and things like that. I do believe that Just as we just talked about in the Q2 of 2020 when COVID hit, we have a very strong balance sheet. We obviously have very strong margins And it's appropriate for us to look at that as opportunities to leverage our balance sheet. Sometimes that may be in the form of extended payment terms or what have you. And our income statement in the form of how we want to go about discounting and supporting growth.

Speaker 3

So I think that Again, the strength that we've had, we have the ability to do those things. If the question is around what are we seeing from some of the enterprise customers and Ken is seeing a lot of this as well. Do we see deals that go from 5 years to 3 years? Sure. Is it more than we've seen in the past?

Speaker 3

I kind of look back at the contract Term data point that we give and say maybe, but not a lot kind of a thing. And on payment terms, the Channel has always offered a financing function. I think they prefer to provide the financing function. And I think we provide support to the financing function to the channel by making capital available to them through payment terms.

Speaker 10

That's really helpful. And maybe just as a quick follow-up, Headcount was up a little bit over 600 people quarter over quarter, up over 21.5% year on year. Just curious how we think about headcount growth either In 2Q or late in the year, again, just given the macro? Thanks again.

Speaker 3

Yes, we are overall, if we

Speaker 2

look at both Heikom and Heikom cost, Probably the same pace, company grows the top line and also try to at the same time, try to improve in some efficiency there. So we are now looking for headcount growth above the top line. Even we feel there's still quite some area, we also need to do some more But the company so far we feel we have a pretty healthy finance model And this also could be the opportunity to also gain in some market share.

Speaker 10

Great. Thanks again.

Speaker 2

Thank you.

Operator

Thank you. Please stand by for the next question. This question comes from Ittai Kidron from Oppenheimer and Company. Your line is open.

Speaker 11

Thanks. Hi, guys, and nice results. My first question, I guess, is on the U. S. Enterprise, so not U.

Speaker 11

S. In general, but just the enterprise vertical, Clearly one of the most important growth opportunities for you long term. Can you talk about progress over there, win rates displacements? And Is the macro making things easier or more difficult for you specifically in the U. S?

Speaker 2

First, we continue to invest the U. S. Enterprise, we also see a huge growth potential for us because we have a relatively small market share. And with all the strong product technology we have, on the other side, the big environment definitely slowed down some of the enterprise Making certain decision whether to refresh or something like that. But on the other side, Our solution has a better lower total cost ownership and also can expand beyond the traditional network And also helping customers to consolidate.

Speaker 2

So I think all this combined together, we do see the U. S. Enterprise definitely is a strong growth in AIF for us.

Speaker 11

Okay, thanks. And then maybe a follow-up on the competitive side and Ken maybe you can talk about what have you seen out of your competitors here in the U. S? Any kind of abnormal activity from discounting or otherwise?

Speaker 2

I think In the slowdown of some of the big environment, definitely, the competitors starting To move more aggressive whether on some discount or offer some free Some percentage of free service, but from our angle, we see we have much better Product position, much broad, like infrastructure coverage and better service and also both on the Performance angle, the product definitely has performed much better for the same function, same cost and same time. Our service also has much more value And cost lower than competitors. So for us, we have not experienced like price pressure or discounts pressure. It's more about how we can increase the coverage, increase the lead gen, the pipeline And also to meet the customer need in this big environment change.

Speaker 11

Thank you.

Speaker 3

I would think that what Ken talked about, I think It's fantastic. I think keep in mind, we don't we have a very, as we kind of talked about in prepared remarks, a very diverse customer base, if you will, between being international, between being very large, mid, small and MSSPs, etcetera. So I don't want to put a policy in place that covers every geography and it covers every customer size. And I think what you're really talking about here is something that for us represents 15% of our business, maybe just a little bit less. And because it's at that size, it's something that we can really more, I think, target our responses to as we get deeper into the selling function As opposed to some odd announcement that we're going to give away services for 2 years or something like that.

Speaker 11

Very good. Thank you.

Operator

This question comes from the line of Angie Song with Morgan Stanley. Your line is open.

Speaker 5

Hi. Thank you guys so much for taking my question. I'm on for Hamza Fodderwala from Morgan Stanley. So could you just share a little bit more about your current interest around the Sassy or current customer interest around the Sassy product? And What are some of the responses around this so far?

Speaker 2

It's a pretty strong growth and also we're working with We've got a lot of service provider, both on the infrastructure side or security service side and offer to SASE, because we do believe SaaS should be an ecosystem with a lot of player instead of just a vendor offer their own SaaS because a lot of I'd say probably most of the customer, they prefer some of their data being processed control themselves, whether some Private SASE or some data sovereignty keeping the data within certain geo. So that's where we see The SASE approach, we call Universal SASE, gave the customer flexibility to offer both cloud based or on premise based Our kind of leverage service provider infrastructure will be more benefit of the whole industry long term. So that's where even sometime, we Kind of take a little bit more time to develop all the SaaS function in the single OS, but that's making it more easy for the customer, for the service Provider to deploy SASE to see their need at their environment. So we see a very, very healthy Pipeline and the strong growth, kind of our salary growth and that's also based on kind of a more healthy margin kind of model instead of losing money all of our growth.

Speaker 2

So we want to maintain that model and also working closely with our partner to offer kind of a SaaS you put into the customer.

Speaker 5

Got it. Thank you. And just one more around profitability. So how are you guys thinking about how much growth slows down over the next few years? And where should we To see that margin leverage.

Speaker 1

Angie, can you repeat that? You cut out in the beginning of that question.

Speaker 5

Yes, no worries. So the question is around profitability and I was just wondering what you guys are thinking about upside to profitability as growth slows down And where should we expect to see that margin leverage?

Speaker 2

We see the midterm Margin will be $10,000,000,000 by 2025 with non GAAP operating margin at least 25% for each year

Speaker 3

in the

Speaker 2

next 3 years.

Speaker 5

Got it. Thank you.

Speaker 3

Yes. I think the one thing, Angie, and I think Hamzah talked Hamzah about this before as well. Keep in mind, 2 thirds of the business roughly is service revenue, and that's producing Gross margin that's in the mid-80s. So and that's those are longer term contracts. So I think we The business model is such that we have time to react if there was something really dramatic that happened in the industry.

Speaker 3

But part of that's for that to happen, I think you'd probably have to See some sort of shift in the behavior of the bad actors, the nation states, the organized crime groups, etcetera, and we don't see that that's on the landscape.

Speaker 5

Great. Thank you so much.

Operator

Thank you. Please stand by for the next question. This next question comes from the line of Tal Liani of Bank of America. Your line is open.

Speaker 12

Hey, guys. What we've seen with good companies in the last two quarters That they make great numbers, but when you look at the composition, new customers are slowing down And sales to existing customers are going up and we've seen it through multiple companies in the space. So the question is whether you can Provide us with some data on sales to existing customers versus new customers and how is the current environment on customer acquisition on new customer

Speaker 3

Yes. So as a reminder, it's all good to hear from you again. If you think of the business being extremely diversified, Whether that's geographically or by customer segments, 1 third small, 1 third mid, 1 third large, we specifically called out in the script that we added over 6,000 new logos in the quarter. So obviously and that's probably a growth rate that's easily in the double digits. New logos take a while to really produce revenue for us.

Speaker 3

It tends to be less than 10% Of total revenue from the new logo, so it creates the opportunity to continue to sell into them. Kind of to Ken's comment a moment ago to your question here, Do we see large enterprises in the U. S. Still moving forward robustly with all their various digital transformation Projects, I think that the word on the street is that slowed down a little bit. And in that environment, I do think that incumbents sometimes have an advantage, but also A cost of performance argument and debate is something that you see customers perhaps more receptive to in the current macro environment.

Speaker 12

And in the current macro environment, is the duration of contracts going down

Speaker 3

or Again, Yes, flat. It was flat year over year, down 1 month quarter over quarter.

Speaker 8

Got it. Okay. Thanks.

Speaker 3

Which just something reminds me in the room very politely. Every Q1 is down 1 month.

Speaker 2

Got it. Sequentially. Yes.

Operator

Thank you. One moment for the next question. This question comes from the line of Andrew Nowinski of Wells Fargo. Your line is open.

Speaker 13

Okay. Thank you and congrats on a nice quarter. So I wanted to ask about your Sassy offering as well. You talked at the Accelerate Conference about, I think having 8 to 10 new use cases driving demand for the firewall, but I'm wondering if Sassy could be one of those use cases as well, meaning Is the firewall appliance a critical component of your SASE offering?

Speaker 2

Yes, SASE definitely is one of the use case, Especially the universal SASE or sometimes they call the private SASE For some customer or some service provider, they want to have more control of their data. So that we see is Both SASE, like the service model, customer benefit service provider has a big way to add to that one, but at the same time, Given the flexibility of merger for some traffic to the cloud or to the power have a process on premise and by the appliance. So that's we see the huge benefit of Universal SaaS solution, which is more different than some other SaaS players And a lot of customers and the partner were interested to this universal SASE approach.

Speaker 13

Thanks, Ken. And then, maybe a question for Keith, just as it relates to your CapEx, you talked about a component of that being used to build out more POPs To support the Sassy offering, but is that something like how should we think about CapEx in that investment beyond 2023 as you continue building out your network?

Speaker 3

Ken and I are smiling at each other. We've had this conversation. I think I've been here for 9 years as of this week. One thing I've come to appreciate is I can behave like a long term investor. And with that in mind, owning critical real estate assets tends to have a better payback than Leasing them over an extended period of time, whether that's in R and D facilities, whether that's in manufacturing or warehouse facilities or that as we move into the SaaS Market as well as other cloud offerings, it's not just investments in Sassy, if you will, but it's also investments in larger data centers in order to deliver various cloud based services and solutions.

Speaker 3

And I think you've heard us talk about that in the last several earnings calls and the guides of data centers having an impact on margins for services and CapEx spending. So I don't think there should be a surprise there, but I think it is an indication of our looking to expand into more fully into some of these other markets.

Speaker 13

Got it. Thank you.

Operator

And thank you. One moment for our final question. Our last question comes from the line of Shrinik Kotari from Baird. Your line is open.

Speaker 14

Yes, thanks for taking my question. So for Ken or Pete, I think Keith, you mentioned about the financial services Up over 40%, which is surprisingly strong and contrary to what we are hearing from your peers and competitors. So Can you expand a bit about upon the underlying drivers? I know you touched upon it, but I just wanted to Span on the geographical diversity or is it increased kind of impetus for vendor consolidation that is benefiting you guys in that vertical? If you can just elaborate and then I have a quick follow-up.

Speaker 3

Yes, I would say it's all of the above. It's happening geographically. I think it's happening with Customers that we took down earlier that are expanding with us with additional firewalls and additional security or additional services as well. I think the market, if you will, financial services, if you step back and look at what's happening there, specifically the firewalls over the last several years, There's probably 2 legacy vendors there that when their contracts are up for renewal and we've talked about this for a long period of time now, they're exposed And it creates an opportunity to come in for a competitive displacement. And I think that some of the other comments or questions today is, is it more difficult in this environment for Competitive placements, I mean sure, you got to work a lot harder to make it happen.

Speaker 3

You got to make your value proposition more well known. But I think again, I think it's Expansion, I think there's opportunity to displace incumbents and I don't think it's specific to any one particular geography.

Speaker 2

Yes. Also from technology angle, we have Two huge advantage. One is for the internal segmentation of security data center, so because the ASIC Advantage we have, we can deploy in a very high speed environment, which a lot of us finance service provider, they do need to secure their Kind of internal segmentation there. The other part really, some of finance service also starting to supporting work from home, working from remotely, which we also have a large Due to a solution without ASIC based like a small appliance supporting this kind of our broad infrastructure approach combined with SD WAN or the other 5 gs, 4 gs network and security together. So that gave us huge advantage from the product angle.

Speaker 14

Got it. Thanks a lot, Ken, Keith. Just a quick follow-up and you guys, of course, touched upon the expansion opportunity In the form factors, of course, your peers and companies have spoken about unit expansion pressures and How the product unit growth is kind of normalizing, but just wondering given that you guys gave examples of this 8 figure expansion and upsell opportunity, replacing kind of firewall with a holistic solution. Can you talk about expansion drivers broadly? Like Are you seeing mostly upsell and expansion in form factors versus the units?

Speaker 14

Just Just wanted to get some clarification.

Speaker 2

Yes, probably both. Yes, we do see the expanding of both the unit And also upsell, cross sell of the entire 40 secondurity fabric, which has a 53 Product, so that's where both our internal sales force and also partners that will not after cross sell for the whole fabric. At the same time, because we combine network and security and more function together, have more deployed case, Which also the unit shipment also starting keeping grow quite nicely.

Speaker 14

Got it. Thanks a lot, Ken. Appreciate it.

Operator

Thank you. Thank you. That concludes the Q and A segment. I'll now turn it back over to Peter Stokowski for closing remarks.

Speaker 1

Thank you, Chris. Apologies to the 7 people we left in the queue. I'd like to thank everyone for joining today's call. Fortinet will be attending investor This conference is hosted by JPMorgan and Bank of America during the Q2. Firestore chat webcast links will be posted on the Events and Presentations section of the Fortinet Investor Relations website.

Speaker 1

If you have any questions, please feel free to contact me. Have a great rest of your day. Thank you.

Operator

And thank you for your participation in today's conference. This does conclude the program. You may now disconnect.

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Fortinet Q1 2023
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