Fortinet Q2 2023 Earnings Call Transcript

Quartr
Provided by Quartr
August 3, 2023

There are 11 speakers on the call.

Operator

Good day and thank you for standing by. Welcome to the Fortinet Q2 2023 Earnings Call. At this time, all participants are in a listen only mode. After the speakers' presentation, there will be a question and answer session. To ask a question during the session, you will need to press star 11 on your telephone.

Operator

You'll then hear an automated message advising your hand is raised. To withdraw your questions, please press star 11 again. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Peter Ziolkowski, Senior Vice President of Finance.

Speaker 1

Thank you, Therese. Good afternoon, everyone. This is Pete Salgasky, Senior Vice President of Finance and Investor Relations at Fortinet. I am pleased to welcome Welcome everyone to our call to discuss Fortinet's financial results for the Q2 of 2023. Speakers on today's call are Ken Zee, Fortinet's Founder, our 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 the Investor Relations website. Ken will begin our call today by providing a high level perspective of our business, keep a lender view of our financial and operating results for the Q2 of 2023 before providing guidance for the Q3 of 2023 and updating the full year, we'll then open the call for questions. To allow others to participate. Before we begin, I'd like to remind everyone that on today's call, we will be making forward looking statements, and these forward looking statements we will conduct the following factors in our most recent Form 10 ks and Form 10 Q for more information. All forward looking statements reflect the opinions only as of the date of this presentation, and we undertake no obligation and specifically disclaim any obligation to update forward looking statements.

Speaker 1

Also, all references to financial metrics that we make on today's call our 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 Ken and Keats' 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 will now turn the call over to Ken.

Speaker 2

Thanks, Peter. Thank you to everyone for joining today's call to review our Q2 2023 results. Total revenue in the 2nd quarter increased 26%, driven by strong revenue growth in service, which top 30% for the 2nd consecutive quarter with 34% growth in subscription and a non FortiGate product growth over 45%, which is nearly $2,000,000,000 annual run rate, building growth of 18% leads to more normalized product revenue growth of 18%. We believe our building performance reflects large enterprise concern with the macro environment in addition to some inventory digestion after 2 years of elevated 30 plus percent product building growth during the supply chain shortage, according to IDC's latest quarterly security tracker, in addition to having the number one unit in firewall category for 10 consecutive year with over 50% market share, Fortinet is now the market share leader in both unit and revenue. Based on the latest Westland Advisory OT Security and Cybersecurity Report, Fortinet was named the only IT OT network protection platform leader, we are currently one of the top And the fastest growing OT security vendor in the market that Westland Advisor expect to grow to $33,000,000,000 by 2,030.

Speaker 2

Fortinet's success lies in our broad integrated platform, our proprietary ASIC security processor and our ability to converge network and security both on prem and in the cloud across a single FortiOS operation system. To leverage these advantages and drive future growth, in addition to our leading network secure solution, we will increase our go to market investment in Universal SASE, SD WAN, OT Security, cloud security and security operations and we will dedicate more resource to support hybrid infrastructure and hybrid work. Today, we announced a new 40 ks 90 gs, our 1st next generation firewall as secure SD WAN appliance with the new security process of 5 ASIC that deliver industry leading security function, performance, scalability and power efficiency and a cost effective price. The FortiGate manages a fully integrated result FortiGuard AI powered and has secured computing reaching that is up to 16 times greater than average of our competitors' similar price model we are using over 90% less power than computing solution. We also announced 2 new SD WAN service underperformance monitoring service to simplify operation and enhance digital experience as well overlay service to facilitate rapid deployment, redundancy and a seamless interconnection of location with 4 d SASE using SPA technology.

Speaker 2

This new SD WAN service showcase our commitment to expanding our service, leverage our leading installation base for additional future growth, we see a single vendor SaaS solution opening a large new market and one where our sizable SD WAN installed base can be leveraged as a significant market access point, together with newly announced SD WAN service, we plan to accelerate our global point of presence PoP deployment with a new strategy of investing in our own POPs as well as working with service providers, Fortinet's recent announced result of an independent analysis by Forrester of the cost saving and the business benefit of deploying 48 next generation firewall and 40guard AI powered secure service within enterprise data center, which include more than 300% return on investment over 3 years, payback in 6 months 90% reduction in time spent on menu updates. In addition, an independent analysis by Enterprise Strategy Group established that customer who deployed Fortinet security operation solution such as Forti EDR and Forti NDR we reduced their time to detect and response to incidents from an average of 3 weeks to 1 hour. This demonstrates the substantial impact that artificial intelligence, machine learning and the integration of Fortinet Secure Op fabric product have our organization's ability to secure today's rapidly expanding attack surface.

Speaker 2

Finally, new development in AI such as generative engine show a lot of promise to various applications in cybersecurity. We believe AI technologies can help us significantly to improve productivity and can be scaled to a large customer base in areas such as malware detection, threat hunting, event correlation and automation, As well as assisting network design and troubleshooting. 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 3

Thank you, Ken, and good afternoon, everyone. Let's start with the key highlights from the Q2. Billings growth was 18% as well as product revenue growth. Service revenue growth held firm at 30%, Resulting in total revenue growth of 26%. OT and SD WAN revenue continued to perform well revenue from these products were up 60% 40% respectively.

Speaker 3

In a sign of our strength in the small and midsized customer segments, we added a record 6,500 new logos. Operating margins of 26.9 percent exceeded the high end of the guidance range by 140 basis free cash flow was strong at $438,000,000 representing a margin of 34%, benefiting from the deferral of certain cash tax payments to the 4th quarter. Looking at billings in more detail, billings of $1,540,000,000 were led by non FortiGate billings at over 30% growth, representing 34% of total billings. Non FortiGate billings growth was driven by networking, FortiGate VM, NAC and cloud. And as Ken mentioned, non FortiGate is nearing a $2,000,000,000 annual revenue run rate.

Speaker 3

In terms of industry verticals, government and manufacturing topped the list as a percentage of total billings, with manufacturing up almost 50%, government and construction were up over 30%, while service provider and retail were up 1% and down 5%, respectively. Retail was impacted by a very difficult compare as the industry vertical nearly doubled in the year earlier period. Billings growth varied by geos with international emerging leading followed by Europe and LatAm. APAC and to a lesser extent U. S.

Speaker 3

Enterprise were challenged by difficult prior year comparisons. Deals over 1,000,000 dollars increased from 122 deals to 134 deals. Turning to revenue and margins. Total revenue grew 26 percent to $1,290,000,000 driven by non FortiGate growth of over 45% and service revenue growth of 30%. This was the 2nd consecutive quarter of greater than 30% service revenue growth.

Speaker 3

Security subscriptions represent over 55% of all service revenue And continue to streak a strong increasing sequential quarterly growth dating back to Q1 of 2022 at 23% The Q2 of 2023 at 34%. Product revenue of $473,000,000 increased 18%. Product lead times and backlog are expected to approach normal levels in the Q3. Total gross margin of 77.9 percent was up 140 basis points, driven by 160 basis point increase in product gross margin to 63.5%. Product gross margins benefited from earlier pricing actions and easing cost pressures and were partially offset by certain inventory charges.

Speaker 3

Service revenues were 63% of total revenues we delivered gross margin of 86.2%. Higher service revenue offset higher labor costs and increased cloud delivery costs As we continue to expand our cloud to SASE delivery models. We see our single vendor SASE solution opening a large new market and one where our sizable SD WAN installed base can be leveraged as a significant market access point. We plan to accelerate our point of presence or PoP deployments with the dual strategy Ken mentioned, investing in our own PoPs As well as working with 3rd party providers to accelerate our deployment. Operating income of $348,000,000 grew 36%, outpacing revenue growth by more than 10 points as operating discipline resulted in significant operating leverage.

Speaker 3

Operating margins of 26.9 percent exceeded the high end of the guidance range and was up 210 basis points due to the strong gross margin performance and operational efficiencies, earnings per share increased 58% $0.38 per share and also exceeded the high end of the guidance. Looking to the statement of cash flow summarized on Slides 7 and 8. Free cash flow increased 55 percent to $438,000,000 Adjusted free cash flow, which excludes real estate investments, $498,000,000 representing a 38.5 percent adjusted free cash flow margin. Free cash flow benefited From the deferral of approximately $190,000,000 in cash tax payments. As mentioned last quarter, these tax payments together with other deferred 2023 tax payments are due to be paid in the 4th quarter.

Speaker 3

Capital expenditures were $77,000,000 including $59,000,000 of real estate investments. Cash taxes in the quarter were 38,000,000 the Board recently increased the company's share repurchase authorization by $500,000,000 and the total available share buyback authorization Is now approximately $2,000,000,000 Now I'd like to share a few significant wins from the quarter that exemplifies the strength of our broad and integrated platform. 1st, a global pharmaceutical leader signed an 8 figure deal to adopt Fortinet's cybersecurity fabric, investing in our OT Aware Secure Networking Architecture as well as our AIOps and Threat Intelligence solution recognizing the market shift to a platform based approach to security, this company selected Fortinet to secure its highly regulated and sensitive medical data as it continues to drive global operational and financial efficiencies through our broad integrated an automated platform approach to cybersecurity. In another deal, one of the largest U. S.

Speaker 3

School districts, with a NAC solution that offers better visibility to the devices connected to the network. Fortinet competed against multiple peers I was able to win due to FortiMax ease of implementation, centralized management capability and superior risk remediation As well as the tight integration with the district's existing Fortinet Security Fabric. This high 7 figure deal was the largest NAC deal in Fortinet's history. Finally, in a 7 figure displacement and our largest 40 Sassy deal ever, a large bank on its digital transformation journey was searching for a single vendor Sassy solution for its hybrid workforce. We selected our 40 SASE solution for its over 5,000 users as it integrates SD WAN and SASE into a holistic solution and delivers comprehensive security both from the cloud and on prem while ensuring consistent security policies for all users regardless of their location and wherever applications are being accessed.

Speaker 3

These transactions illustrate how Fortinet's platform strategy, integrated operating systems and proprietary ASIC technology continue to resonate with customers. Given the heightened interest in AI technology, we cannot do this call without discussing Fortinet's investment and innovations in AI. Fortinet has been at the forefront of AI and machine learning innovation for many years, leveraging deep learning artificial neural networks To power our products and security services, enabling a faster, stronger and more accurate defense for our customers, one of our first AI powered use cases was the introduction of the virtual FortiGuard Threat Analyst. FortiGuard addresses threats in real time with machine learning, coordinated protection and is extensively used in malware detection and threat hunting. Every time a threat is identified, FortiGuard generates threat intelligence that automatically updates defense signatures across the fabric.

Speaker 3

In cloud environments where scale and speed are critical, AI and machine learning can help security teams keep pace with threats on multiple fronts. All of this happens seamlessly and behind the scenes. Today, our platform ingests and analyzes on average more than 100,000,000,000 events every day to deliver over 1,000,000,000 security updates daily across the Fortinet security fabric and ecosystem. While many of our competitors OEM their security from different security vendors, our AI driven FortiGuard threat intelligence has been built in house, Which allows us to use AI across different sources. Adversaries increasingly are using AI in their playbooks to drive cyber attacks, which only increased the rapidly evolving cybersecurity threat landscape.

Speaker 3

We continue to invest in AI and machine learning technologies across our products, including generative AI, natural language models and other implementations to enhance, simplify and automate security for our customers. Before moving to guidance, I'd like to offer some observations about the Q2 and about the industry. Regarding the 2nd quarter, we believe macro uncertainty impacted our billings performance through average contract duration and in the second half of June an elevated level of enterprise deals pushing the future quarters. We saw shorter contract duration With the average term decreasing by 1.5 months to 28 months creating a 4 to 5 point billings headwind year over year. Normalizing billings growth with a change in contract duration yields billings growth in the low 20% range.

Speaker 3

Having some level of enterprise deals pushed to future quarters is not unusual. In Q2 2023, however, an unusually large volume of deals we expected to close in June instead push to future periods. From a market perspective, CIOs continue to prioritize and invest in securing their organizations in the face of rising cybersecurity threats. We see new regulatory requirements such as the recently announced those recently announced by the SEC in the EU Cyber Resilience Act announced earlier this year, it will continue to provide market tailwinds as organizations further increase their cybersecurity we will continue to comply with new stringent cyber regulations. The cybersecurity industry remains highly relevant CIOs prioritize cyber spending within their overall IT budgets.

Speaker 3

As such, the longer term demand drivers for Forinet remain very solid. That said, we do see a return to more normal seasonality for Fortinet in the back half of the year as tailwinds such as the supply chain driven growth subsides And we cycle prior period price increases. Moving on to guidance. As a reminder, our Q3 and full year outlook, which are summarized on slides 11 and 12 are subject to disclaimers regarding forward looking information that Peter provided at the beginning of the call. For the 3rd quarter, we expect billings in the range of $1,560,100,000 to $1,620,100,000 which at the midpoint represents growth of 13% And is consistent with our quarter over quarter seasonality prior to the pandemic.

Speaker 3

Revenue in the range of $1,315,000,000 to $1,375,000,000 which at the midpoint represents growth of 17%. Non GAAP gross margin of 75.5% were 76.5 percent, non GAAP operating margin of 24.5 percent to 25.5 percent, non GAAP earnings per share of $0.35 to $0.37 which assumes a share count of between $795,000,000 805,000,000 capital expenditures of $100,000,000 to $130,000,000 non GAAP tax rate of 17%, cash taxes of $25,000,000 And as previously mentioned, backlog is expected to approach normal levels in Q3. For the full year, we expect billings in the range of $6,490,100,000

Speaker 2

to $6,590,100,000

Speaker 3

which at the midpoint represents growth of 17% and implies slightly below normal seasonality in Q4. Revenue in the range of $5,350,000,000 to $5,450,000,000 which at the midpoint represents growth of we feel the midpoint represents growth of 28.2%. The service revenue guidance implies product revenue growth of 13.5%. Non GAAP gross margin of 75.25 percent to 76.25 percent, non GAAP operating margin of 25.25 percent to 26.25 percent. Non GAAP earnings per share of $1.49 to $1.53 which assumes a share count of between 7.95 $805,000,000 capital expenditures of $335,000,000 to $385,000,000 due to our continued cloud, data center and facilities investments non GAAP tax rate of 17%, cash taxes of $460,000,000 was approximately $380,000,000 in the 4th quarter.

Speaker 3

We continue to execute our long term strategy and remain confident in the strategy and our solutions. While it's a little early to be providing guidance for next year, we would expect our near term performance to represent a short term trough. Given our confidence in our solutions, our offerings and taking into account that growth comparisons will ease as we move through 2024, At this early stage, we would expect buildings growth to approach high teens by the Q4 of 2024. And with that, I'll now hand the call back over to Peter to begin the Q and A session.

Speaker 1

Thank you, Keith. Operator? Yes. Just one quick reminder before doing the Q and A, if you could please limit yourself to one question, one follow-up question.

Speaker 4

Operator, you

Speaker 1

can open the call.

Operator

Thank you. Our first question is from Randy P. Morgan. Your line is open.

Speaker 4

Hi, good afternoon and thank you for taking the question. Ken, I think you noted that and Keith Commented to it as well, reflected, I guess, the billings performance and guidance reflects enterprise concern about the macro. Could you give a little bit more color there and what you saw from a macro perspective? And I think you pointed to weak service provider business. I think investors might draw parallels to what they saw with Juniper last week on the carrier side, maybe if you could include a few thoughts on how dynamics there may be similar or different With regard to what you see, and then I have a follow-up.

Speaker 2

Sure. I think for the carrier service provider, we do see they're probably a little bit behind offer some service Because the carrier service provider, if you look back 10, 15 years ago, is our biggest market is like about 30% market share comes from the carrier service provider. Nowadays, security need additional service, like some SASE, all these function additional security function in the SASE, we should service provider kind of behind. So we're still working with them closely, try to help them accelerate the service. At the same time, we also starting to invest a little bit more of self, which also like together with the new service we announced today, the 2 new SD WAN We feel investing certain infrastructure that will help and drive a lot of new service going forward in the security space and also helping service provider to kind of accelerate some of their security service beyond the traditional security service they have.

Speaker 3

Yes. I would probably add to Ken's comments, Particularly as we talk about service providers, but some of the other verticals in customer segments, and I

Speaker 5

think there's some lessons that

Speaker 3

we can see from, for example, manufacturing was extremely well in the quarter. They continue to have I feel they think they're under pressure in the threat environment. So you see them It's been fairly richly. It's no surprise if you look at the government sector, which was strong also. They have governments in the slowing they have budgets in the slowing economy That maybe some of the other industries don't.

Speaker 3

And then at the other end of the spectrum, Ken talked about service provider and people I think are aware of that story there more broadly, But also retail, I think retail is really a very clear indicator of a vertical that can be one of the first that sometimes impacted by a slowing economy, but also, Ken made This concept of digestion, a lot of purchasing around SD WAN technologies and implementations. A year ago, you saw very, very high growth a year ago. And now going through a digestion period such to the point that it's actually negative growth in the retail vertical.

Speaker 2

We're also interested in some cloud provider also starting to get into the security space, which also kind of Confused some of the enterprise customer. So that's also sometime they take a little bit more time to evaluate our different So we do believe there's a hybrid approach on premise in the cloud and all would be best for the customer. Even the cloud probably much more expensive. Our cognitive average about 3 to 5x more expensive compared to on premise, but it's the combined altogether probably will be the best solution to customer.

Speaker 4

Got it. That's helpful. And maybe a quick follow-up for Keith. I think you talked about a reinflection to high teen billings growth Next year, how does performance this quarter and your outlook for the rest of the year impact the 2025, I guess $10,000,000,000 billings target that you'd previously thrown out there?

Speaker 3

Yes. I think that as we go through the second half of the year and we enter into the normal planning cycle for 2024, I think that will be a logical output at that point in time to think through what we're seeing in terms of our 2025 targets.

Speaker 4

Okay, that's helpful. Thank you.

Operator

Thank you very much for your question. One moment. Our next question comes from Gabriela Borges with GS. Your line is open.

Speaker 6

Hi, good afternoon. Thank you. Keith, I want to stay on the medium term outlook, your comment on high teens billings growth By 4Q 2024, if I heard it right, maybe just talk us through how you thought about derisking the 6 month and the 18 month Kind of outlook and what are some of the leading indicators you're looking to determine when billings growth and product revenue will trough? Thank you.

Speaker 3

Yes, I don't know Ken if you want to talk about longer term trends in the industry and I'll avoid guidance for 2024 if we do that.

Speaker 2

If you look back to like 30 years, we jumped in the industry, network security still have a pretty good pace of growth probably between 10% to 20% on average in the last like 30 years. And we feel we have a very unique, huge advantage solution, which we that only one build our own ASIC. You can see the product we announced today, which has a probably average about 10x better performance, more function Compared to competitive solution and also much less energy consumption, probably like 90% less energy consumption. So that's where the new SP5 actually the first product announced actually is that we have a 14 application engine integrated into the ASIC chip, Probably more than double compared to the previous version. That's also helping drive the next few quarter growth, Which is probably every quarter we may plan to announce the product using SP5, and that's a huge advantage and then also drive to the long term convergence of network into network security, which Ghana agreed by 2,030, the network security will be larger than the traditional network in there.

Speaker 2

So that's what we'll continue to drive the network security side growth. On the other side, we also mentioned a few other area we see kind of the non FortiGate part also growing pretty strong, so 45% is part of it because consolidation, part of it because certain Like security budget allocation to certain cost spending can be allocated to some security And the other part also kind of like how to manage among different kind of vertical and also some inventory That's also we try to balance. We do believe since we'll be recover in the later part of next year and because the last 2 years we see quite a strong product revenue growth, 7 quarter even over 50%, which is not quite normal, But as once things get normal, so that will be pretty much return to the investor average in the last 20, 30 years, Which is about 10% to 20%.

Speaker 3

Yes. As I kind of take that commentary and pull it forward a little bit into say Q3 and Q4, I suspect I'll get a fair amount of chance opportunities to talk about the guidance setting process for Q3 and Q4. I guess I would start off by saying, we've certainly seen over the last 2 or 3 years in the various environments we've been in, you got to be fairly nimble in terms of your assumptions and what you're looking for. And with that in mind, I think I called out in the comments to see the level of deals that pushed in the 2nd part of June The new development, we always have linearity of the deals closed to see the deals push. And I think one comment I would offer is that as you look as I look at the Q3 guidance setting and the roll up, The assumptions for Q3 related to close rates and term and things of that nature and push, I would say look a lot more like the assumptions that we saw in actual results for Q2 than maybe what we saw with some higher rates or better rates earlier on.

Speaker 3

So I think there's Some caution built into that if you will. I think also if you kind of look at the results where the guidance ends up, You can look at top line growth in Q3 versus Q2 that I think is in the low single digit growth sequentially. And that's pretty much in range of where we've seen Q2 to Q3 historically, and we would expect that again. And then maybe just a little more caution in the 4th quarter where and again made a comment earlier that the seasonality assumption that falls out of the guidance for the full year and is applied to the 4th Quarter actually suggests a lower level of growth in the Q4 than we've seen in other periods. You're offering a certain degree of caution, number 1, but also acknowledging that Q4 last year was a very strong quarter and pretty tough compare.

Speaker 2

Also, we do see some strong growth in the new area like SD WAN OT, which grew 40% 60%, total count of 25 25% of units and also the 5 gs growth not quite stopped yet. So we all have the best product for all these new solutions. So that's additional growth drive As we're keeping developing.

Speaker 6

That all makes sense. Thank you. And just to clarify, is it safe to assume that 4Q Q or are you assuming that 4Q billings will be the trough of billings growth?

Speaker 3

Yes, I'd have to go back and look at the actual compares because the compares start easing and I don't want to mix up bookings and billings in this conversation because the timing is a little bit different. But I think that the growth in billings in Q4 and Q1 of last Q4 of last year and Q1 of this year were very, very strong.

Speaker 2

Also, you can refer to the finance presentation number 10 page, which we go back to 13 years Since we IPO 13 years ago, so there's some kind of a growth, some kind of margin information.

Speaker 6

Yes, I do like that slide 10. Thank you for calling that up. Okay, thank you.

Speaker 2

Thank you.

Operator

Thank you very much. Our next question will come from Kyle Liani with Bank of America. Your line is open.

Speaker 7

Yes. Thank you. I'm going to ask my 2 questions together with your permission. The first one is Palo Alto is posting their quarterly call for Friday evening, which is always a bad sign historically for a bad quarter. And then you are reporting weaker than expected, although you were very positive last quarter.

Speaker 7

I remember the calls. So does it mean that the environment deteriorated in the last 3 months? And if the environment deteriorated, what is the source for it? Meaning, is it the backlog drawdown issue that we were concerned with before? Or is it that customers are deciding not to buy, push out?

Speaker 7

I'm trying to understand the meaning of Both you and Palo Alto, 2 successful companies kind of comments. The second question is, Keith, in your remarks, you said that projects were pushed out. But if it were pushed out, why do we see a deceleration, Continued deceleration into 3Q and 4Q because I can back out your 4Q guidance and billings is declining from 18% to 13% to 11%. And if it was a push out, then we would have seen recovery in the second half from push outs from 2Q. So how do you connect your comments about push outs versus cancellation to the numbers to the guidance?

Speaker 7

Thanks.

Speaker 3

Yes. I'll go first and then Ken can talk about what his friend down the street is doing. I'm not doing it for the best of his knowledge. As I kind of alluded to, I'm not Yes, I had push outs in the quarter. I'm happy with what I saw in terms of July on deals getting closed.

Speaker 3

But I retained the concept of continuing push outs in Q3 and Q4. I'm not scared to suggest that there's going to be a 1 quarter recovery in that. I think

Speaker 5

that this is going to be

Speaker 3

take a little bit longer Through this economy kind of normalizes and this digestion process goes on. So I think it's really, yes, picking up something in Q3 from Q2, but I'm also anticipating I'm going to see some things move from Q3 to Q4. And also the compares, if you go back and look at it Q3 and Q4 on the billings line, Those are pretty attractive numbers that we put up in Q3 and Q4 of last year. What's he up to?

Speaker 2

I don't know why Pollard is selected Friday afternoon, which is probably I'm not the one to answer the question. But on the industry, we do see some company, especially large companies, little bit more tight on the budget And also kind of take a little bit long time to close it. It's not just this quarter, basically pretty much starting early this year. There is some sign of that one. How long will last is tough to say, but Usually, the security is starting to underspend, then they probably will be starting to go back up after probably a few quarter.

Speaker 2

On the other side, you do see when the big environment starting kind of a tough or tight, they tend to be more hung on the current product, current solution and then buy more service, which we also try to helping customer leverage whatever they Have on hand to offer more service like SD WAN service we announced today. So that's the service revenue starting kind of we're doing well, leverage our kind of last few years, the product revenue growth, which we already be the number 1 in the product revenue in the whole which is over 28% market share and also unit shipments over 52% market share. So I think we'll continue to keep leading in the Based on the new technology solution like the 40 gigabytes, 90 gigabytes we announced today, but it's For us, we're more focused on long term. So we do believe the long term convergence of network to network security. We feel we have the best technology product To me that challenge and at the same time, the short term environment we tend to be also see as an opportunity to keeping gaining market share.

Speaker 7

Got it. Can you talk about I know you don't provide backlog, but can you talk about the backlog trends and how much of what we're seeing last quarter, this quarter, next quarter is still supported by backlog versus the environment itself? We are all looking through this. The question is whether first half of twenty twenty four, for example, we can get to single digit growth instead of the double digit you talk about the end of the year. So I'm not asking you for guidance for first half, but trying to understand How much of current trends are supported by backlog?

Speaker 2

Yes, the backlog, I see, are already back to normal now, back to like before the supply chain issue. And you can see last year towards the middle to the end, we already see the 40 ks, we already solved the issue. The majority or most of the backlog come from some network related product. That also being eased up in the first half of this year. I see backlog is kind of back to normal before the supply chain issue.

Speaker 2

And they do have certain cancellation, I see the cancellation probably double digit.

Speaker 3

I think Ken's giving you not the accounting answer on backlog numbers, but the CEO version that he's done worrying about it and he knows the company can manage their way through it. From a numbers viewpoint, we still have some backlog that we that will pick up some low single digit benefit in Q3. And then to Ken's point, we think that largely as you get out of Q3, we'll have a we'll be back to very close to normal backlog numbers.

Speaker 7

Great. Thank you.

Operator

Thank you for your questions. One moment please while we compile the roster. Our next question is from Brad Zelnick with Deutsche Bank. Your line is open.

Speaker 8

Thanks very much for taking my questions. I want to ask one of Tal's questions maybe a little bit differently. A lot of what you shared suggests your market Position remains strong and we've always thought that the price performance advantage of your architecture Should enable you to actually take share in a tougher environment. I guess what many are trying to figure out is if it's tough for Fortinet, does that implicitly mean It's tougher for others out there. And is there anything maybe you can share on competition that would be helpful, perhaps win rates or pricing dynamics that you're seeing in the market?

Speaker 2

I think we still have the best solution at special level of the ACIP chip. So the product revenue still grew 18% compared to I think checkpoints of minus 12%, I believe, and some other vendors say it's low single digit. So we still feel we're keeping gaining market share. On the other side, we also see consolidation, so it's leverage our installation base. We see some of the other products that are in kind of helping sell.

Speaker 2

But on the other side, probably 2 other kind of maybe timing related issue. 1 is you can see the last 2 years on the product revenue growth, it reads on Page You can see the product revenue growth probably lies 40%, 50% in some quarter, but all over 30% in the last 2 years. So I do believe some kind of inventory has been hold by certain customer or some under my partner or alternative service provider channel, and we also kind of changing the policy, our service grace period policy early this year, I think in March or April, which instead of give some of the channel like 1 year the Can Am Able service, we tightened that up to like 90 days, which can help reduce some inventory levels in certain panel there. At the same time, we do announce the SP5, I think it's early this year. And today is the first product available based on the new ASIC SP5, we reach probably like 4 or 5 times better performance and more applications being accelerated and at the same time, at the same cost.

Speaker 2

And it's kind of a I do believe certain partners, certain customer may be also waiting for some of the new product Leverage latest technology, so that maybe also has certain kind of impact.

Speaker 3

Brett, I would great question and kind of follow on with Ken there. When I look at the win rates for, say, our top 3 competitors, right, and you know who they are in the firewall market, I'm not really seeing a change in the win rates, the win loss rates. They were quite consistent,

Speaker 5

maybe improved in one of

Speaker 3

the three cases that are the names that we know. I think that what we don't know is how much it is specific to us was that we had deals teed up for the last couple of weeks of the quarter That we're on a path to close and they did not close. So how I think the question becomes, is that something about the macro and the enterprises Pushing out spending a little bit or is it some area that we need to improve on in terms of how we go about our own internal inspection and forecasting And look at the detail of deals, right. We'll know more about that as time plays out.

Speaker 2

Yes. The net sales slowdown is more because of very strong growth. 1 year ago almost doubled, now it's going to slow down. The carrier service provider Do not ramp up yet, so we do hope they will ramp up soon.

Speaker 8

Thanks for that color, Kenny. And just my follow-up, Keith, as we think about pricing, which has been A tailwind across the whole market, I think, given supply constraints over the last couple of years. Can you give us any update of what the trends are now as supply eases and what's embedded in your assumptions for your guide on billings for this year and next? Thanks.

Speaker 3

Yes. I think that when we look at or go back to our approach we've had for many years when we introduced a new product and you heard about the 90 the 90 gs today, our starting point is even though it has superior functionality, capacity, throughput, etcetera, is we generally price that along the lines of its predecessor. I think one thing that we're seeing as we move into the second half of this year is some opportunities to take maybe some targeted pricing actions around use cases. For example, maybe if you get really far down the low end of the market, where you're dealing with some low cost franchisee models, maybe we would Take some opportunities there to perhaps offer some incentives to our channel partners and such to participate in that market. So I think the margins are obviously very, very strong on the product side and we have that benefit there.

Speaker 3

So I do think it gives us the opportunity to make certain investments in the second half of this year, whether you want to call it price list or discounts or rebates or incentives to the channel

Operator

our next question is from Angie Song with Morgan Stanley. Your line is open. Hi. Thank you guys all so much for taking my question today. In terms of cancellation rates, could you guys give us any directional color on backlog cancellation rates and what's assumed in your guidance by year end?

Operator

Thank you. And I have a follow-up after.

Speaker 3

Last quarter, I think cancellation rate we said was high single digits. This quarter, we say it's low, low double digits, Right. And I don't as backlog continues to subside, as Ken pointed out a moment ago, it's not really going to make that much of a difference whether that cancellation rate goes from Low double digits to mid teens or something or even 20.

Operator

Got it. Thank you. And just as a follow-up, what percentage of revenue came from SD WAN and OT Security this quarter?

Speaker 2

We think together over 25%, Pretty similar to past few quarters, but also going pretty strong, 40% SD WAN, 60% OT, I think.

Speaker 1

You're over 25% of the bookings number. I think we've given a revenue number for that.

Operator

Perfect. Thank you, guys. Thank you. Our next question comes from Saket Kalia, from Barclays, your line is open.

Speaker 9

Okay, great. Hey, guys. Thanks for taking my questions here. Ken, maybe just to double click on the competitive question a little bit, but 0 in on one segment. I'm wondering how you're seeing Sassy vendors in this market, meaning do you feel like the growth Maybe backing up.

Speaker 9

Keith, very helpful comment just on how the competitive win rates trend versus the other traditional network security providers. But When you look at Sassy, do you feel like the growing prevalence of Sassy is impacting firewall appliance decisions at all?

Speaker 2

I think it's a little bit different market. Somehow the service provider, the traditional telephone service provider or the security service provider, they are a little bit behind in the last 5 to 10 years. So that's gave the SaaS provider to offer the service, but I do believe a lot of our telecom service provider, cloud provider, they have a you get advantage on infrastructure and the cost advantage to offer some additional security service, so which we are also working closely with At the same time, we also invest some of our own kind of infrastructure because also a lot of our additional service beyond SASE like the ICWAN, some larger FortiTrust or FortiCare service also need some of the infrastructure, Which will make a more profit model, cost efficient model compared to some other SaaS provider they have To better lease or whatever, we tend to like double, triple the cost compared to the seamless service, they're owning the infrastructure. That is the new service offered by the SaaS provider we do see we meet certain enterprise needs, which we also started to invest more in this area.

Speaker 9

Got it. Got it. Keith, maybe for you for my follow-up, very helpful commentary just on the billings duration in the quarter. I think that definitely helps bridge The GAAP was at least the guide on billings in Q2. But maybe looking forward, how are you thinking about billings duration for the second half of this year?

Speaker 9

And I don't know, is there a way to kind of do the same exercise like what would billings have been if the duration would have been in line with your original plan?

Speaker 3

I'm going to need a spreadsheet for the second part of that question. I'll come back.

Speaker 9

No, no problem. We can take it offline.

Speaker 3

No, that's fine. I think there's been conversation over the last say 3 or 4 quarters about would duration slow down and we commented that we had seen some slowdown in duration, not 1 month a quarter, but it would kind of bounce around a little bit. The point I'm making is when you're measuring year over year growth, we lost 1.5 points of duration, which works out to be about 4 or 5 points of growth. So when you're making the comparison, on a growth basis, it really is a factor there. And then if you want to get into the spreadsheet part of it, remember that Product is not impacted by duration, only services are, so you get a partial impact.

Speaker 3

I think if you're looking forward, as I made the point, As we look at Q3 and Q4, the duration assumption I would say is in that pool of things that I've looked at what we saw in Q2 in terms of actual results and how those some of those metrics and assumptions that go into the guidance setting process differed from what I've been seeing for the prior few quarters In place of very heavy reliance on what I saw in Q2, whether that's deals that push or that term or a bucket of other things. So without going into specifics, I would probably answer that question That

Speaker 9

way. Very helpful.

Speaker 2

Yes, some additional point on SaaS is where the especially a lot of We do see a lot of like we call it universal SaaS, which is supporting both on premise In the office and also work from home, because if you back in office, forward all the office traffic To the part of our subsidy provider and the process sent back to the office not make much sense. And at the same time, we do see a lot of leverage our SD WAN leadership there, we do see a lot of required single vendor SASE and also some bigger company also they To do the Kotel private SASE solution, so instead of process the SASE traffic in the service provider probably one to one process in their own kind of

Speaker 4

Thank you.

Speaker 3

Thank you.

Operator

Our next question comes from Shaul Eyal with TD Cowen. Your line is

Speaker 1

open. Thank you for taking my question.

Speaker 10

Good afternoon. Keith or Ken, can you maybe talk about the performance that you've seen with your go to market as it relates to your top resellers, was there anything non balanced this quarter?

Speaker 3

I'm not quite sure. Are you looking for The distribution of salespeople hitting quota or I'm not sure that I follow the question. You try to

Speaker 10

get So actually, I'm looking for your value added resellers, your notable ones, the biggest one And whether performance was even or balanced or not during the quarter?

Speaker 3

Yes, I don't have that data handy, to be honest with you.

Speaker 2

Yes, we do see some release from exclusive network, which probably one of our biggest distributors also we are also one of their biggest distributors probably 30,000,000,000 business compound, but they're a little bit more

Speaker 3

Sorry, I was talking about resellers. I'm sorry. Sorry, sellers. No, no, no. You're asking the right question.

Speaker 3

No, no. You're that one, distributors.

Speaker 2

Yes, I think it's a similar comment as we are seeing.

Speaker 3

Yes, I don't think the mix of our business, if you will, shifted at all significantly. We look at our top 3 and our top 6 distributors. We're fairly concentrated in that regard. That mix doesn't really change all that much, maybe a point or 2 in a quarter. There wasn't something that we saw that jumped out there, Paretosh.

Speaker 2

Yes. Also even go back to the history also going forward, Also put a similar kind of a forecast, I believe.

Speaker 3

Yes.

Speaker 10

Thank

Operator

you. Thank you for your question. Our next question comes from Joseph Gallo with Jefferies. Your line is open.

Speaker 4

Hey, guys. Thanks for the question. Given the breadth of your platform, you have a better vantage point than most. When you talk to CSOs, where is the relative health in the cyber budgets? And where are you seeing the most resistance?

Speaker 4

And then given your optimistic comments on 2024, what lends confidence that this is only a 1 to 2 quarter digestion period? Is there any historical context to support that?

Speaker 3

In terms of SISO spending, obviously, there's the things that are getting media attention out there now, I suspect that we sit down with a SISO, they'll be talking about it, whether that's SaaS or something with some of the AI technologies or what have you, but I don't think that CISOs and CIOs can get away from having to take care of They're knitting, if you will, with their infrastructure. There are always seem to be new use cases for firewalls There are opportunities, if you will. Those use cases still exist on prem that need to be secured. There's new use cases in the cloud, the edge, etcetera. I think it's a very difficult We are positioned to be a CISO right now with budgets and threats that are after them.

Speaker 3

As it relates to 2024, I think, whatever pardon me, 2024, We'll go through our planning cycle more religiously as we do the second half of the year. I think the point that Ken and I were making is really Yes, as we move back to a more normal buying pattern after we move through the supply chain in the pandemic and so forth, that's what the industry has been historically and we would have every expectation that Yes, we'd be able to get back in that sweet spot, if you will. And I would also note that it's not a static And by that, I mean the comparison is getting easier, it seems, each and every quarter as you go through 2024?

Speaker 2

Yes. The SESO, we talked to, they still have a certain shortage of people they can leverage to support in whether work from home or hybrid work environment. And So that's where they tend to a little bit more try to use in certain service kind of approach. On the other side, they We need to make sure that the new infrastructure, like whether supporting back to office or supporting like We call it universal SaaS, universal DT and A environment because there's like So many tech service starting kind of impact and plus the new area like OT security, that's kind of But also certain security budget, they also because some company, they commit certain cloud spending, sometimes leverage is not commit spending for certain security. We also see some of that case.

Speaker 2

So that's what happened. So that's where we also kind of keeping enhance or helping the secure operation, which is also most of CECL feel how to support in their operations are pretty big to I have helped in to solve the issue there and also leverage some kind of AI, some new technology and also kind of more broadly deployed, a security inside the infrastructure is also supporting hybrid work environment is also Quite a high priority for them.

Speaker 4

Thanks. That's very helpful. And then I guess as we work through this How should we think about investments in hiring? You've outperformed in the first half on profit, but yet your guide doesn't necessarily reflect A continuation of that, where should we think of the incremental investments from here and the classic growth versus profit debate at billings moderate? Thanks.

Speaker 2

We're still hiring and but also the hiring probably will be a little bit behind on the top line growth. Make sure we're keeping improving the productivity efficiency, but also we probably will also Kaidu has certain hygiene process, which we kind of not quite do in the last 2, 3 years during the pandemic, which certain low performer, we probably need to be kind of more disciplined To have certain performance, we will kind of discipline there.

Speaker 3

Yes. I would use that to kind of come back to I think Shaul's Let me make a couple of points. I think that as Ken kind of pointed out that we've had a lot of sales people. We certainly have sales capacity to deliver on the numbers. At the same time, I think we've been very faithful to when we talk about 25% operating margin and you see us continually coming in above that.

Speaker 3

So we have the opportunity there to invest more. And on that note, I think that the conversations with the channel partners, the distributors I think they're much more informative, deep, detailed at the right levels now than they were a few years ago. There's a lot more cooperation and information sharing With the distributors and I think a byproduct of that is I think there's some opportunities for us to maybe to invest in our channel partners in a variety of different ways As we go through this next 12 probably 6 to 12 months.

Speaker 2

Yes. I kind of keep referring to the Page 10, The last 13 years, the growth margin, so that's where we have the margin and we've been All the 30 years since IPO, so if we need to invest in the growth, we definitely have the margin to do that. But on other side, we also want to keep a healthy model and take care both on the growth and margin. Thank you.

Operator

Thank you. And our next question comes from Andrew Nowinski with Wells Fargo. Mr. Nowinski, your line is open.

Speaker 5

All right. Thank you. I want to ask about the geographic demand trends. So you saw I think you saw strength in international regions in Europe. I was just wondering how Sustainable, do you think that demand is in those regions?

Speaker 5

Or are they just maybe 1 to 2 quarters behind the U. S. In terms of seeing the impact from the macro?

Speaker 3

Yes. I think that we have a competitive advantage when you look at Europe and parts of Emerging where we are oftentimes viewed as being the incumbent of our number one market share. So in an environment in which maybe the IT budget start Suffer more in Europe than they do in the U. S, which is not what we're seeing currently, right? Currently, we're seeing the IT budgets are lower in the U.

Speaker 3

S. Than they are in Europe Based on some recent surveys, I think we're better prepared to work our way through that in Europe because of our dominant position in that market.

Speaker 5

Okay, got it. And then I think you talked about seeing strength in the SMB segment, adding about 6,500 new logos. I guess I was wondering as it relates to your universal SaaS solution, can you just talk about maybe how you're competing against, if at all, against Microsoft's new entro solutions that are targeting that market.

Speaker 2

Yes, we kind of more leverage our huge Installation base and also the technology, the product, which address the network security. Microsoft definitely have some good customer base in the enterprise side, but on the network security, which is addressed more beyond the So the enterprise definitely have some advantage there. And also we have not seen Microsoft have any solution address network security Thanks for security area. So we do believe there's opportunity for both companies.

Speaker 5

Got it. Thank

Operator

you. Thank you. That concludes our question and answer session. I would now like to turn the call back to Peter Ziolkowski for closing remarks.

Speaker 1

Thank you, Therese. I'd like to thank everyone for joining today's call. Fortinet will be attending investor conferences hosted Deutsche Bank, Goldman Sachs, Oppenheimer, Rosenblatt and Stifel during the Q3, Far East and Chat webcast links will be posted in the the presentation section is forwarded at the Investor Relations website. If you have any follow-up questions, please feel free to contact me. Have a good rest of your day.

Speaker 1

Thank you.

Operator

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

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Earnings Conference Call
Fortinet Q2 2023
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