Fortinet Q1 2024 Earnings Call Transcript

Quartr
Provided by Quartr
May 2, 2024

There are 14 speakers on the call.

Operator

Good day, and thank you for standing by. Welcome to the Fortinet 1Q24 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 session. Please be advised that today's conference is being recorded.

Operator

I would now like to hand the conference over to our first speaker today, Peter Salkowski, Senior Vice President of Investor Relations. Please go ahead.

Speaker 1

Thank you, Brianna. Good afternoon, everyone. This is Peter Salkowski, Senior Vice President of Finance and Investor Relations at Fortinet. I am pleased to welcome everyone to our call to discuss Fortinet's financial results for Q1 of 2024. Joining me on today's call are Ken Xie, Fortinet's Founder, Chairman and CEO Keith Jensen, our CFO and John Whittle, our Chief Operating Officer.

Speaker 1

This is a live call that will be available for replay via webcast on our Investor Relations website. Ken will bring our call today by providing a high level perspective on our business. Keith will then review our financial and operating results for the Q1 of 2024 before providing guidance for the Q2 of 2024 and updating the full year. We'll then open the call for questions. During the Q and A session, we ask that you please limit yourself to 1 question and one follow-up question to allow others to participate.

Speaker 1

Before we begin, I'd like to remind everyone that on today's call, we will be making forward looking statements, and these forward looking statements are subject to risks and uncertainties, which could cause actual results to differ materially from those projected. Please refer to our SEC filings, in particular, the risk factors in our most recent Form 10 ks and Form 10 Q for more information. All forward looking statements reflect 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, which we make on today's call are non GAAP unless stated otherwise. Our GAAP results and GAAP to non GAAP reconciliations are located in our earnings press release and in the presentation that accompany today's remarks, both of which are posted on our Investor Relations website.

Speaker 1

The prepared remarks for today's call will be posted on the quarterly earnings section of the Investor Relations website immediately following the 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

Thank you, Peter, and thank you to everyone for joining our call. Q1, we managed business with strong spending discipline and increased our operation margin 200 basis points to a 1st quarter record of 28.5%. We also generated record cash flow from operation of $830,000,000 and our adjusted free cash flow margin was 61%. We remain focused on investing in the fast growing unified SaaS and secure operation market, which combined accounted for 1 third of 1st quarter billions. We continue to gain security networking market share, leveraging our advanced differentiated FortiOS and FortiAC technologies with an increasing number of large customer adopting our industry leading secure networking solutions.

Speaker 2

Last month's attendance and our annual accelerated conference increased 25% year over year to nearly 5,000 participants. Our unified SaaS and new AI offering dominate the discussion with our partner and customers. For the Q1, Unified SaaS accounted for 24% of total billings. To introduce customer and prospect to our new unified SaaS solution, we plan to run attractive promotion this year in 2024. For several reasons, we believe no cybersecurity company come close to a differentiated unified SASE solutions.

Speaker 2

First, we have developed all Unifin SaaS functionality into 1 single operating system, the 4 d OS. This includes our 4 networking and security stack, comprised of LDT NA, Secure Web Gateway, CASB and our market leading SD WAN and firewall technologies, providing content, application, user, device and location awareness to reduce attacks. 2nd, our unified SaaS solution can be deployed on premise in the cloud of both. Peer solutions send traffic to copy the POP, increasing security risk and latency and is less efficient. Last, Fortinet unit by SaaS offer both traditional software endpoint agent and hardware agents such as 40 WiFi Access Point and 40 Switch for customers with easier deployment and the more broad use case such as unified SASE for OT and IoT devices.

Speaker 2

We expect our differentiated unified SASE offering to emerge as the SASE leader. Fortinet's advanced platform approach has been earning 3rd party award for many years. Last month, we entered the Gartner Magic Quadrant for Secure Service Edge. As shown on the Slide 12 in the investor presentation, Fortinet is the only vendor recognized in the Gartner Magic Quadrant report for security service edge, SD WAN, single vendor SASE, network firewall and enterprise wireless LAN infrastructure. All 5 secondurity and network offering from Fortinet are uniquely built on one operation system, FortiOS and leverage our Forti ASIC to increase secure computing power for more functions and better performance while lowering the cost and energy consumption.

Speaker 2

Putting a secure op solution, which are better integrated and automated together than competitors accounted for 9% of total billings. Initially launched as part of our Forti SIM and Forti SOAR, our gen AI technology Forti AI is being deployed across both networking and security product. And today, we announced the industry first IoT security generative AI assistant. Customers can ask Forti AI to help in 30 plus languages. Fortinet is also the market leader in OT security solutions, the fastest growing space in network security with billions of device connected online.

Speaker 2

And most OT device has a limited computing power, making network security the most effective means of securing them. Today, we announced the FortiGate 200 gs, a mid range firewall powered by a new SP540 ASIC with secure computing rating of 3 to 10 expected performance around competitors and industry average. Reinforcing our leading secure networking and even SASE advantage that provide customer with industry leading security functions, performance and power efficiency. Before turning the call over to Keith, I wish to thank our employees, customers, partners and suppliers worldwide for their continued support and hard work.

Speaker 3

Thank you, Ken, and good afternoon, everyone. Let's start with the key highlights from the Q1. As Ken mentioned, we continue to manage the business through the macro uncertainty and successfully drove operating margin to a Q1 record of 28.5 percent exceeding the high end of the guidance range by 200 basis points. Free cash flow of 609,000,000 dollars represented a 45% free cash flow margin benefiting from strong Q4 2023 billings and their subsequent collection in Q1 of 2024. Billings of $1,410,000,000 and revenue of $1,350,000,000 were within their respective guidance ranges.

Speaker 3

Looking at billings in more detail, while Unified Sassy and SecOps delivered strong billings growth, total billings declined 6% as expected. The billings performance was driven by the difficult year earlier comparison created by the backlog contribution to billings that occurred in last year's Q1. Total bookings were down just slightly. Unified SaaS and SecOps had outstanding growth across a variety of benchmarks in the Q1. In addition, we saw significant progress from our investments in Unified SaaS and SecOps.

Speaker 3

These include cross selling into our large installed base. Existing customers delivered over 90% of SecOps and Unified Sassy Billings. On an even more targeted basis, existing SD WAN customers delivered 81% of unified Sassy billings. Larger enterprises are proving to be our largest customer segment with large and enterprise large and mid enterprises representing 78% 84% of SecOps and Unified Sassy Billings respectively. Even with increasing scale, both pillars have strong pipeline growth, 30% for SecOps and over 45% for Unified Sassy.

Speaker 3

More importantly, within Sassy, the SSE pipeline growth is over 150%. Our investment in Sassy is being recognized by 3rd party agencies. We recently recorded the trifecta with Gartner's Sassy Magic Quadrants, SSE, SSE WAN and single vendor Sassy. And as Ken noted, with last month's addition to SSE, Fortinet now appears in 5 network security Card Magic Quadrants, again, all running on a single operating system. With the Sassy Magic Quadrant trifecta, customers have shown increased interest on learning more about our unique Sassy platform that runs on the 1 operating system with 1 unified agent, 1 management system and one data lake.

Speaker 3

To offer an example of customer interest at our Accelerate conference early last month, the Sassy demo booth was our most active as customers surveyed Sassy's new features and functions including end to end digital experience monitoring, remote browser isolation, advanced data loss prevention and 3rd party SD WAN connectivity. As a second example, nearly 25% of the accelerated attendees who joined our CMO for the Sassy breakout session. The attendee number for this breakout session would have been even higher if it wasn't for the fire marshals regulations that forced us to turn away customers and partners who are eager to hear more about the Sassy offering. And to offer one final example, the customer and partner Sassy Fast Track training program at Fortinet which launched in January is already this number 2 most attended technical training session training only a single vendor SASE partner SD WAN. We're committed to driving more effective security solutions worldwide and welcome greater partnership with our industry peers.

Speaker 3

The new 3rd party SD WAN connectivity technology is designed to support consolidation not only on Fortinet, but with Fortinet. In terms of scale, we continue to open new Google and Fortinet pops in sync with our customers' expanding footprint and driving the deployment scale demanded by large enterprises. And a quick update on that 7 figure of 300,000 seat education mentioned last quarter, the full production environment was activated in March and we are on track to have their 300,000 plus seats on board to start the new school year. To expand on Ken's earlier comment about today's AI related announcement, Fortinet's Gen AI assistant follows our Forti AI launch last year by supporting and guiding SOC and NOC teams as they configure and manage changes to their network and investigate and remediate threats. Its intuitive interface allows individuals to engage using 30 different natural languages, bridging the industry skill shortage.

Speaker 3

I encourage everyone to visit fortnett.com to learn more about the Gen I Assistant. Rounding out our billings commentary, SMB was the top performing customer segment, International Emerging was our best performing geography and our 3 largest industry verticals continue to be worldwide government, service providers and financial services. Service provider and worldwide government experienced the highest growth, while retail and financial services were a bit more challenged. As noted in our prior call, the 6 8 figure deals in Q4 2023 pushed our average contract term in DSO to elevated levels. The average contract term in the Q1 was 27 months, down just under 1 month year over year and 3.5 months quarter over quarter.

Speaker 3

DSO decreased 12 days year over year and 23 days quarter over quarter to 66 days. Turning to revenue and margins. Total revenue grew 7 percent to $1,350,000,000 driven by service revenue growth. Service revenue of $944,000,000 grew 24%, accounting for 70% of total revenue and a revenue mid shift to services of 10 points. Service revenue growth was led by over 30% growth from Unified Sassy and SecOps.

Speaker 3

Product revenue decreased 18% as expected to $409,000,000 coming off a challenging 35% year earlier compare impacted by backlog fulfillment in the prior year. Software license revenue increased 20% and represented a mid to high teens mix of product revenue. Total net product bookings were down just slightly. Combined revenue from software licenses and software services such as cloud and SaaS security options increased 29% and represented an annual revenue run rate approaching $750,000,000 Total gross margin of 78.1% was up 180 basis points and exceeded the high end of our guidance range benefiting from the mix shift to higher margin service revenues. Service gross margins of 87.9 percent were up 200 basis points as service revenue outpaced labor cost increases and benefited from the mix shift towards higher margin FortiGuard security subscriptions.

Speaker 3

Product gross margin of 55.7% as we saw were pressured as we saw challenges related to inventory levels and the transition to a more normalized demand environment. Operating margin of 28.5 percent was 200 basis points above the high end of our guidance range, reflecting the strong gross margins and prudent cost management. Looking to the statement of cash flows summarized on Slide 16 and 17. Free cash flow was 609,000,000 dollars Adjusted free cash flow, which excludes real estate investments, was $821,000,000 representing a 61% adjusted free cash flow margin. Infrastructure investments totaled $222,000,000 including $212,000,000 of real estate investments.

Speaker 3

Cash taxes in the quarter were $31,000,000 And while we did not repurchase shares in Q1, share buybacks have totaled 5,300,000,000 over the past 4 plus years and the remaining buyback authorization is $1,000,000,000 Now let's share a few significant wins from the Q1. I'll start with the 1 8 figure deal in the quarter, a competitive displacement and new logo win. This large U. S. Financial institution selected Fortinet as part of their data center update and consolidation project.

Speaker 3

Keys to this win included our experience in this highly regulated customer data sensitive industry and our ability to lower the total cost of ownership and exceed their low latency performance requirements. Similar to other large financial institutions separating from their incumbent, this customer is expanding their forward net footprint by adding our SD branch solution and planning to consolidate additional technologies. Next, in the competitive 7 figure win, a hospitality company that serves over 5,000,000 guests annually updated their various Fortinet solutions including the FortiGate firewall footprint and FortiNac solutions. Keys to expanding our relationship included our price to performance advantage on the firewalls and the NAC solution's proven ability to discover and lock down devices that attempt to join their network together with the operational simplicity and integration of the dozen different Fortinet solutions the customer uses. In another 7 figure deal, a hotel and restaurant chain purchased our SD branch solution for 800 locations as well as our data center FortiGates for centralized management and enhanced security.

Speaker 3

This solution from our network security pillar included firewall switches and access points as well as a variety of software products. The SC branch solutions bring improved efficiency and security over their branches and IoT devices. Key to this win and in other retail opportunities is enabling retailers to deploy, expand and deliver a growing array of in store digital solutions to support their customers' experience and increase their top line performance. As these customer wins illustrate, our Security Fabric platform includes each of our security pillars, unified SaaSci, AI driven SecOps and secure networking, making it the most integrated, most open portfolio of products in the industry, backed by 1 operating system, FortiOS, 1 unified agent, FortiClient, 1 management console, FortiManager, 1 data lake, 40 analyzer and open APIs and integration with over 500 competitor and other third party products. This integration allows customers to consolidate security solutions thereby reducing operational costs while increasing security effectiveness.

Speaker 3

Moving to guidance. As a reminder, our Q1 and full year outlook, which are summarized on slides 21 and 22, are subject to disclaimers regarding forward looking information that Peter provided at the beginning of the call. For the Q2, we expect billings in the range of $1,490,000,000 to $1,550,000,000 which at the midpoint represents a decline of 1%. Revenue in the range of $1,375,000,000 to $1,435,000,000 which at the midpoint represents growth of 9%. Non GAAP gross margin of 76.5 percent to 77.5 percent, non GAAP operating margin of 25.75 percent to 26.75 percent.

Speaker 3

Non GAAP earnings per share of $0.39 to $0.41 which assumes a share count of between 7.75 $785,000,000 capital expenditures of $30,000,000 to $40,000,000 a non GAAP tax rate of 17% and cash taxes of $240,000,000 to $270,000,000 Before updating the full year guidance, I'd like to elaborate on the backlog headwinds easing in the second half of twenty twenty four and share what we believe we are starting to see as early signs that the firewall digestion cycle is nearing completion. First, the billings headwind from last year's backlog drawdown is over $150,000,000 in 2024 and gradually diminishes throughout the year with no headwind in the 4th quarter. And second, we're looking for early signs of a more normalized firewall market. One metric we watch is the average days to register security service contracts as shown on Slide 19. In 2022, we noted the days to register has increased about 50%, which was consistent with customers buying and stocking behaviors at the time.

Speaker 3

More recently, this metric decreased by about 25% from its peak and is now consistent with late 2021 levels and is on a pace to return to normal levels in the second half of twenty twenty four. A reasonable read through of the data is that customers are completing the inventory digestion process and are on the path to a more normalized firewall buying behavior. And with that for the year we expect buildings in the range of $6,400,000,000 to $6,600,000,000 revenue in the range of 5,745,000,000 dollars to $5,845,000,000 which at the midpoint represents growth of 9%. Service revenue in the range of $3,940,000,000

Speaker 1

to $3,990,000,000

Speaker 3

which at the midpoint represents growth of 17%. Non GAAP gross margin of 76.5 percent to 78 percent. Non GAAP operating margin of 26.5 percent to 28 percent. Non GAAP earnings per share of $1.73 to $1.79 which assumes a share count of between $780,000,000 790,000,000 Capital expenditures of $350,000,000 to $400,000,000 a non GAAP tax rate of 17% and cash taxes of between $500,000,000 $550,000,000 dollars I look forward to updating you on our progress in the coming quarters. And I'll now hand the call back over to Peter to begin the Q and A session.

Speaker 1

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

Operator

Thank you. At this time, we will conduct the question and answer session. Our first question comes from the line of Hamzah Fodderwala from Morgan Stanley. Your line is now open.

Speaker 4

Good evening and thank you for taking my question. Perhaps both for Ken and Keith, you spoke to a lot of green shoots in your prepared remarks, SMB service provider growth looks a little healthier. You're getting recognition on Sassy and you spoke to competitive replacements. That said, the billings in Q1 was a bit closer to the lower end of your guidance versus the high end. So just curious what drove that?

Speaker 4

And what gives you confidence based on where you're seeing the pipeline to maintain your guidance and continue to assume a reacceleration in the top line in the back half of the year? Thank you.

Speaker 3

Yes. I'll talk about the full year. I think that if you look at where we ended up in the Q1 inside the guidance range, just a little bit of weakness that we saw in Europe, just enough to move us off the midpoint, but not really a big movement in terms of where we are in our final results compared to the midpoint. And if we look at where we end up with the total for the year, I don't think we're at all far off from the plan that we thought. Maybe there's some more and twosies there that you're kind of pointing out.

Speaker 3

But as we look at the pipeline to your point, I think the mix that we see in our pipeline today together with some of the hygiene improvements that we worked on for the last 6 to 9 months, I think we feel better about where we end up with the full year numbers, if you will. I think at the same time when you look at the full year numbers and some of the outperformance in the quarter or better performance if you will with service revenue and product revenue you see us bringing that number up a little bit. But importantly at the same time you see us also bringing up the margin number on the bottom line by about 3 quarters of a point.

Speaker 2

Yes. I think the high interest rate making the money kind of more expensive have a lot of enterprise kind of probably more favored OpEx instead of a CapEx for some of the network and security project. So that's where that's also the reason we're starting shifting the focus more on the kind of a SaaSy or kind of secure op, which is really more helping company, saving the cost and the same time kind of more some kind of OpEx model. So that's probably at the same time, we do making some adjustment in certain product price back to like a per pandemic level before the supply shortage. That's happening in Q1 probably has a little bit impact, but it's overall, I think the product competitive is still very, very strong.

Speaker 2

We still see a lot of replacement of our competitor product, which is kind of be more expensive. And especially the new FortiOS introduced last month with more function, including all the function, the unified SaaS, all these things drive a lot of attention from the customer and they are all interest to this new OS and the new product we have launched.

Speaker 4

Thank you.

Operator

Thank you. And one moment for our next question. Our next question is from Gabriela Borges of Goldman Sachs. Your line is now open.

Speaker 5

Good afternoon. Thank you. For either Ken or Keith, I'd love to get an update on your pricing strategy more broadly. More specifically, how do you think about the trade off between discounting when you're cross selling a broader bundle of portfolios such as SecOps or SSE Services versus being able to capture some of the value from the cross sell? How do you think about that trade off?

Speaker 5

Thank you.

Speaker 2

I think our price strategy pretty consistent in the last 20 plus years. We want to maintain a healthy gross margin and also healthy margin for the partners. And when we see certain cost increase like during the supply chain shortage, whether the component cost or some shipping cost increase, we kind of increase the price. But now some of the cost coming down, we also kind of returned some margin to the partner and also lower some product price to match the per pandemic level. But I think all this price change, we think it's over.

Speaker 2

And also, we're probably more focused on the new product and which follow kind of a healthy margin guideline. I don't think we have adjusted any pricing for the existing product anymore. It's really more focused on when we introduce the new product, we just want to make sure it says healthy margin for all the parties.

Speaker 5

Thank you.

Speaker 2

Thank you.

Operator

Thank you. And one moment for our next question. Our next question comes from Brian Essex from JPMorgan. Your line is now open.

Speaker 6

Great. Thank you for taking the question. I appreciate it. Maybe for Ken, in terms of the Sassy traction that you saw in the quarter, how much was SD WAN conversion? And maybe a little bit if you could give us a little more color on the split of the customers that you saw in that business, the split of maybe large, mid, small enterprise, so we can get a sense of competitively, how you might be lining up against some of the peers in that SaaS market?

Speaker 2

I think that's a great question. I think we have a slice for that.

Speaker 3

Peter might have asked trying to ask that question. Yes. I think we also included in the prepared remarks.

Speaker 6

Peter read my mind.

Speaker 3

And I'll tap dance here while somebody files the actual slide number for you, Brian. But, yes, I think that existing customers were over 90% for both SaaS and for SecOps. So they were expansion sales. And Ken's kindly pointing out to me my slide number 8 that's in the deck that actually gives you a little more context for it. One change you may notice there is that for the 1st few quarters when we talked about customer mix and the expansion opportunity, we did it by customer counts believing that we were going to have a lot of penetration with the SMB space and that was where you get a larger number to start seeing some patterns.

Speaker 3

What we've now seen is that the large enterprises and the mid enterprises are actually dominating both of those pillars of growth. And with that, we've just converted those pie charts to dollar values, which is more traditional where we expected to get eventually.

Speaker 6

Okay, great. Thank you for that. Maybe just as a quick follow-up on that topic. I think you mentioned, if I'm not mistaken, unified SaaS E, 81% of I'm sorry SD WAN, 81 percent of Unified Sassy billings. And I think you might have given us that metric to back end SD WAN last quarter, if you could

Speaker 3

maybe say a little bit more. Yes. Brian, what we're trying to say there is that, I think we're there's a common belief internally and probably externally that we're going to have a lot of success with the Sassy solution by cross selling our existing SD WAN customers. And so the Sassy billings that we saw this quarter, I believe the number was 81% of those were existing SD WAN customers.

Speaker 2

Yes. And also we build SD WAN function into FortiOS, which whenever you have a 40 ks, we believe like close to 60%, 70% customer all have the by the 40 ks, they have automaticized to function. And so that's where we do see other SD WAN current SD WAN customer, which we are not fully tracking because they're part of OS function free of charge. We do believe a lot of them are interested to convert into SaaS, full SaaS function there.

Speaker 6

Got it. That's really helpful. Thank you very much. I really appreciate it.

Speaker 2

Thank you.

Operator

Thank you. And one moment for our next question. Our next question is from Fatima Boolani from Citi. Your line is now open.

Speaker 7

Thank you. Good afternoon. I appreciate you taking my question. Keith, I wanted to have you spend a little bit of more time talking about some of the geographic theater level performances. So we've seen a pretty material deceleration in your Americas business.

Speaker 7

EMEA has been relatively resilient and APAC's actually shrunk this quarter. So I was hoping you can put a lens on each one of those geographies to talk about any nuances or idiosyncrasies from a demand and or buying perspective And then just a follow-up with regards to if you can talk about the pipeline and pipeline growth you're seeing with secure SD WAN proper considering that is such an important conduit for future SaaS upsells? Thank you.

Speaker 3

Okay. Where to begin? Kind of cherry picking through some data points. I think 1, 1st and foremost, the SMB continues to perform stronger than expectations, whether that's external to the company or from other sources, if you will. It's very resilient.

Speaker 3

And I think it's simply the breadth of the SMB space together with, as I've said in the past, the success of the channel program. I think Europe was just a tad bit light in the quarter and a little bit on their enterprise side of their business and probably just enough as I said before to move us off of the midpoint of our guidance. I think what we spent a fair amount of time with more recently is looking at where the 8 figure deals coming from. And if you're looking at the deceleration and let's take the U. S.

Speaker 3

Enterprise as an example of that. Last quarter we talked about 6, 8 figure deals in the business. The vast majority of those were in the U. S. Enterprise.

Speaker 3

This quarter, we gently noted that we had one 8 figure deal. And so you can see that those 8 figure deals can whipsaw that growth rate for the U. S. Enterprise around quite a bit really because of their opportunities in these 8 figure deals that maybe some of the other geos don't have. We really don't have those opportunities in APAC and in some of the other geographies that we see in the U.

Speaker 3

S. I think the other part of growth, I mean, I think we have to understand where the firewall growth is right now in terms of the industry. And with that, it puts a lot of either pressure or opportunity for us to sell the SASE solutions and the SecOps solutions. And you're probably seeing a little more maturity in the ability to sell or the openness to buy SecOps and SaaS solutions in the U. S.

Speaker 3

And in Europe, the larger economies than

Speaker 2

you are in APAC. Also Japan probably count about is the biggest country for us in APAC, probably 1 third or more APAC, which the currency, like the U. S. Currency pretty strong against Japan currency recently, that may also have some impact of some slowdown there. On the other side, we do see most SD WAN customers definitely more interest in the SaaS.

Speaker 2

And also in the current environment, more and more customer starting to turn SD WAN because SD WAN definitely give them a cost saving. So on average, it's about 50% cost saving compared to the traditional MPLS or other networking function there. So we do see more and more customer first convert into SD WAN customer and then using the same 40 bps setting, adding additional SaaS function there.

Operator

Thank you. Thank you. And one moment for our next caller. Our next question comes from Tal Liani of Bank of America. Your line is now open.

Speaker 8

Hi, guys. You gave some comments at the end of your prepared remarks about signs of recovery of the firewall market. And would you mind to repeat that? You went over it quickly. And the question is also with it, do you expect the non FortiGate to recover?

Speaker 8

Is there a correlation between the 2? Do you expect the non FortiGate to recover and or does it have its own cycle? On the first question, which is about the firewall recovery, do you see that the market share situation is changing, meaning the share gains you experienced in the 3 years of the boom cycle. Do you have any reason to believe that it's going to slow down or you're going to maintain market share gain? How does it change when the market recovers?

Speaker 8

What drives the share dynamics to change or to stay stable? Thanks.

Speaker 3

You want to take the market share and the dynamics and then I'll go through the algebra of the Slide 19.

Speaker 2

Yes. I think we believe we continue gaining market share even right now in the last quarter in the we call secure networking, which are both the firewall and also some other like for the WiFi, for the SaaS space there. And I think because whether the strong performance advantage we have, all kind of more function can give a customer like a better ROI return and a better security and also more deploy case compared to the traditional firewall. So, we feel we're keeping gaining market share. But overall, I have to say that whether the network security firewall market or the network market definitely has going down like 10% to 20% year over year.

Speaker 2

But even in that market condition, we keep gaining more share market share in this environment. Keith probably answered the deck question.

Speaker 3

But yes, for people that have access to it, Slide 19 in the deck.

Speaker 2

And for those a lot of

Speaker 3

you who follow the company for quite a while and remember that we have some pressure on software revenue early in the pandemic and we talked about things like the impact from our share, but also that we seeing a delay in customers registering the service contracts that attach to the hardware contracts. And if you look at that chart, you can see that that delaying activity really started at the end of 2021 peaked at the end of the beginning of 2023, kind of plateaued and now has moved down. And what we believe is you're seeing there is that when the supply chain hit, customers bought the equipment, put it on the shelves and did not need to register the contract as quickly and that's why you saw the increase in the days of register. Now as we move through the digestion cycle, you're seeing that inventories come off their shelves and those days to register are starting to return to normal. We're not quite there, but we're actually quite close to it.

Speaker 3

And I would just offer that I think, as I said, by the second half, in the second half of this year on the current pace, we would return to where we were at pre COVID on that metric. And again, we think that's a very good indicator of where customers are in the digestion

Speaker 8

cycle. Got it. And what about the question on non FortiGate? What are the cycles with the non FortiGate on the non FortiGate side?

Speaker 3

Well, first of all, you're going to get me in trouble for using the term non FortiGate. We talk about SaaS and SecOps, but we're all showing our age here a little bit.

Speaker 2

The non FortiGate probably count probably around 10% of our product. That's probably I see that the networking side is definitely down a little bit, but there's some other like whether the 40 WAV, 40 Mail, some other we see 48 and that we see pretty strong growth. So it's a mix. But overall, I think pretty much similar like FortiGate is a mix, but definitely we see. And on the other side, we do see some early signs of interest customer using WiFi AP, UM46 as a hardware agent for the SASE.

Speaker 2

So that's also one of the promotion we're going to run is really offer some customer. If they get a full WiFi, they probably can run some free full SASE function for some time. So that's we see could be driving additional non-forty gig growth. But we actually all the non-forty gig product, we also have technology we call the FortiLink. It's all linked with FortiGate, like FortiGate, whether it's kind of the 9 Gen firewall host or SaaS host working together with the Forti WiFi or FortiSwitch.

Speaker 8

Thank you.

Operator

Thank you. And one moment for our next question. Our next question is from Rob Owens of Piper Sandler. Your line is now open.

Speaker 9

Thank you very much. Keith, I want to build a little bit on your answer to Fatima's question earlier. And I believe you used the technical term of whipsawing when it comes to growth when you saw 6 large transactions, very large transactions in Q4 and 1 in Q1. And just I want to ask it relative to health and enterprise and what you're seeing here in the pipeline. Should we expect similar types of results in terms of those very large deals as we move throughout the year?

Speaker 9

And how do you think the pipeline is setting up in relative health of the enterprise? Thanks.

Speaker 3

Yes. I feel good about it. And I think we're the parallel that I've drawn in conversations before is that if you went back to 2015, 2016, you saw the company moving away from or expanding beyond the SMB space and doing $1,000,000 deals. But it wasn't that there was enough $1,000,000 deals we couldn't get website by them then. Now we've got plenty, well, I can take more, plenty of $1,000,000 deals, but the $10,000,000 deals are whipsawing us around a little bit.

Speaker 3

You saw that with a very strong performance in the Q4. And I think we're pretty open about that in the Q4 setting expectations for the first. One thing we have spent some time doing is going back and looking at the number of 8 figure deals we have by quarter for say the last 3 or 4 years. And you're looking at a model that maybe had 1 every other quarter or 5 years ago, to now where you're probably averaging something on the order of 2, perhaps 3 of opportunities over a full year per quarter. They're going to get condensed sometimes in certain quarters.

Speaker 3

With our business model and the history, you see that Q4 obviously outperforms as does Q2 typically perform strongly. And I suspect that as we look forward, we'll see a little more concentration of those 8 figure deals certainly in Q4 and maybe some in Q2. Thank you.

Operator

Thank you. And one moment for our next question. Our next question is from Saket Kalia of Barclays. Your line is now open.

Speaker 10

Okay, great. Hey guys, thanks for taking my questions here. Ken, maybe the first one is for you. I was wondering if you could just talk a little bit about how your conversations are going with customers around their plans to refresh their firewall appliances? And maybe specifically, when would we sort of expect that firewall refresh to sort of begin?

Speaker 10

Does that make sense?

Speaker 2

Yes. I see there's a 3 part of the business. One is like Keith mentioned, it's really the digestion, whatever, a supply chain issue. I think that's pretty much over, maybe just a few more months will be all normal. And the second part is really the refresh, which is the current customer, or to the new product, which has a better customer may stretch the current part a little bit longer.

Speaker 2

And but we do see more case, we call it replacement and also the new area like OT, IoT security. So we do see the repayment pick up quite well, which when they're facing like whether you need a new function like the new SD WAN function or the strategy function, a lot of big enterprise starting using our product to replace a more competitive product because they have to offer like multiple product to match one of our 40 gate, 40 OS solution there. And we also have a much better performance and power efficiency. We're using the computer reading to measure for every product. So that replacement case definitely picking up quite well.

Speaker 2

The refresh probably would still need some time to come. And on the other side, a new area like OT, IoT security, we see very, very strong growth. So that's a new market because usually all this OT device not connect online or kind of connect online has no protection and pretty much impossible to run endpoint software because of different operating system and even computing power. So we see this new OT IoT space pick up quite well. That's the new market.

Speaker 2

So long term wise, I still believe the network security market continue to grow like 10% to 20%, but probably will be more mixed in the current environment, probably a little bit more towards the OpEx model, which is kind of a SASE. But for us, the differentiation is really we have all the SASE in the same FortiGate OS, which customer can run right on premise or in the cloud and the power. So we do see a lot customers that then turn on the SASE function, maybe starting to turn on the SASE function first and then additional SASE function, additional SASE service. So that's the way they are starting doing now.

Speaker 10

Got it. Got it. And maybe the follow-up is on that point, Ken, if I can stay with you. Just on that topic of refresh and replacement, is there any sort of change in thinking for those customers about firewall versus SASE? And I mean as part of the discussion, you mentioned pricing earlier, are you getting any sort of pushback on just appliance pricing since sort of the prior round of adjustments that you did sort of during the supply chain?

Speaker 2

We have not seen any pricing pressure discount because we tend to be much better performance and more function because our ASIC technology and none of our competitor has. On the other side, during customer considered a new function they needed for security or higher network speed environment, I think compare us to some competitor because competitors sometimes they just cannot keep adding new function like all the SCUN or SaaS function in their existing firewall. For us, it's very, very different. So we have all the SD WAN function, all the new SASE function built in into the same FortiOS running on different kind of 40 ks device there. So that's also kind of helping customer to really keep adding additional functions, sometimes without really replacing the existing hardware.

Speaker 2

So that's really helping the customer keeping kind of adding service and enhanced security with new function there. And also that's also driving a lot of our replacement of our competitor solution, especially in the big enterprise environment. So that's where we see the strongest growing area for us actually is enterprise customer, which they a lot of them under some finance stress because the high cost of the money, but we do see that the growing in our enterprise space is very, very strong and a lot of replacement of competitive solution using the FortiGate, which has a more function, better performance, low cost and also more efficient on the energy consumption there.

Speaker 10

Super helpful. Thanks guys.

Speaker 2

Thank you.

Operator

Thank you. And one moment for our next call or our next question. Our next question comes from Brad Zelnick of Analyst. Your line is now open.

Speaker 9

Great. Thank you so much for taking my questions. And because we just had 2 for Ken, I think I'm going to now go for 2 with Keith, if we could. Keith, first one, I think pretty straightforward with $1,000,000,000 left in your buyback authorization and the strong cash generation of the business. I was surprised to see you not buyback any stock in the quarter.

Speaker 9

Can you just remind us of your approach to buybacks? And if any change in thinking around use of cash and specifically M and A?

Speaker 3

Peter's pointing at our COO for M and A answer. So we're all listening leaning forward here what he wants to say. I don't think there's been any real change in our find our buyback philosophy. The term we use is we're very opportunistic. We do put a program in place with 1 of the Wall Street firms each quarter and we renew it.

Speaker 3

I think the important part there is looking at the $5,000,000,000 that we bought back over the last 4 years. And it's not that we're doing some other companies would do X percent of free cash flow or something like that. It is really looking for market opportunities. And when we see them, Ken typically steps in and has something set up in that regard. And now our CEO John Whittle has been getting a chance to join.

Speaker 3

Thanks John. Thanks John. Thank you for the question. On M and A, we've always been very, very disciplined. We've done some very strategic tech and talent tuck ins.

Speaker 3

And I think you'll see we're open minded. We consider M and A as it makes sense, but that's definitely been our approach so far. And I think you'll see that approach continue, although we will be at the moment about M and A as it makes sense.

Speaker 9

Thank you for that. And maybe just my follow-up.

Speaker 3

I'm sorry, please.

Speaker 2

Probably is the most busy time in the last 10, 20 years now to look at our different companies.

Speaker 3

Yes. We see a lot of opportunities in the security space for sure. And so yes, we build a pipeline just like sales build a pipeline and we consider them as they come along and reach

Speaker 2

out to us on productively as well.

Speaker 9

Got it. That makes all

Speaker 3

the sense in the world.

Speaker 9

And you guys have done a great job of it over the years. Maybe just on the margin discipline that and the leverage that we're seeing in the quarter. Keith, can you maybe just give us an update on headcount plans and where you are year to date And as maybe relative to 3 months ago, how enthusiastic you are and where you are in sort of pushing or pulling back on the throttle to continue hiring and how we should think about OpEx? Thank you.

Speaker 3

Is that Ken, would you say something on Hyrule?

Speaker 2

It's okay. I think we continue to invest balance the growth and margin. So the area like a lot of R and D long term product, we continue to invest and we do the selected hiring. And also we also take this opportunity to making the management ratio or structure a little bit better. So it's more investing in the field, sales engineering and also the R and D area and the kind of a more flat on certain management level and making the whole company more efficient?

Speaker 3

Yes. I think the study aside the fact that I need more resources in finance, but I was hoping Ken was just going to announce that, but I'm not. I think the business model, Brad, you've seen it through the cycles where if you look back at 2017, for example, and you look at the gross margin number, when you start to see the slowdown or the pause, the cycle in the hardware, you start to see the mix shift to the really rich services. And then as the market recovers, you see that relationship change a little bit. Clearly, we're in a situation right now where the firewall market that the mix shifted 10 points to services and I think that was 87% gross margin.

Speaker 3

It's making margin targets very achievable, let's put it that way. And I would imagine, I think we've raised it by 3 quarters of a point at the midpoint for the full year. That's a pretty big move at this point and I think we feel very comfortable with that as we look at the rest of 2024.

Speaker 9

Excellent. Thank you.

Operator

Thank you. And one moment for our next question. Our next question comes from Ben Bollin of Cleveland Research Company. Your line is now open.

Speaker 11

Thanks. I appreciate you taking the question. Good afternoon, everyone. Keith, I was hoping you could talk a little bit about the receivables drawdown and the DSO performance. I believe you made a comment on your prepared remarks about large deal impact in collections, but it does look like DSOs are below what we've seen for the last few years.

Speaker 11

So I'm curious if there's a change in working capital management, anything notable there?

Speaker 3

No, I don't think it really changed. I think there's always a few puts and takes, if you will. I think the real driver was that last quarter we had those 6, 8 figure deals. And I believe all those closed in the last week or 2 of the quarter. And so that put a lot of pressure on DSOs.

Speaker 3

And only having one 8 figure deal this quarter, which I believe closed fairly early in the quarter, not really in the mid quarter, but not in the last week. So I think that's really all I would point to there.

Speaker 11

Okay. And the last one for me, You talked a little bit about duration. If you step back, a lot of your business is done through the partner community. Do you have any thoughts on how much of that business is being financed by the partners themselves to manage this kind of CapEx to OpEx appetite? Any thoughts there would be helpful.

Speaker 11

Thanks.

Speaker 3

Yes. I think when you say partners, I would say that all the large distributors are working with are offering financing programs either in some cases that might be through their own captive, but I think more often not it's white labeling somebody else's product if you will. I think there's also some of the larger resellers are also offering financing. I think that where it makes a little more sense for ourselves as an OEM is on larger deals, whether we move to the extended payment program or working with the channel to provide them capital, if you will, for the financing. I think there's a lot of different ways to go there.

Speaker 3

But I don't think that I don't think good credits, so to speak, are suffering because they can't find credit. I don't think that's the issue.

Speaker 11

Thank you.

Operator

Thank you. And one moment for our next question. Our next question comes from Adam Borick of Stifel. Your line is now open.

Speaker 12

Awesome. And thanks so much for taking the questions. Maybe for Ken, last quarter you talked about a great job with increasing traction with enterprise agreements. And I was hoping you could talk, obviously, I know 1Q is typically a smaller EA quarter. Maybe talk a little bit more about the EA strategy overall and the go to market efforts to more systematically drive these enterprise agreements, especially in the back half of this year?

Speaker 2

Yes. I think we do see when we have a more enterprise customer and they also want to be long term customer and also with many different products like the consolidation strategy they have right now. We see more EA and at the same time with that one, we definitely see kind of a bigger deal and also kind of a more long term customer booking with us right now.

Speaker 3

Yes. I think that and John took this over, so he gets to make that victory lap on EAs. But as Ken kind of alluded to it, it tends to make a lot of sense when you're most usually going to see it as part of your expansion inside of a larger enterprise. You're probably not going to see it frequently with the very first sale into a new logo you could. And I think some things that are really we're starting to see resonate there are the new 40 points program that we make available and things of that nature where customers have reached that point where they're very comfortable for the technology and our customer support etcetera.

Speaker 3

And they start thinking about long term relationships. They know they're going to buy more. They may not know what. But the combination of EAs and 40 Points, I think has been well received by the customer group.

Speaker 12

That's great. And maybe just as a quick follow-up, in the slide deck, I didn't recall seeing the breakout of the FortiGate by small, medium and large. I know that indicator has been less meaningful more recently. I was just curious if there's anything interesting there as you think about the FortiGate sales by size? Thanks again.

Speaker 3

No, I think you alluded to that. I think it's really you see us at this point in the firewall lifecycle firewall cycle, it's really for us we want to increase the focus on SaaS. I think we feel very good about it. You see it's adding some more information there. And to your point that it wasn't anything that was really new or earth shattering on the Forti Gates.

Speaker 12

Great. Thanks again.

Operator

Thank you. And one moment for our next question. Our next question comes from Keith Bachman of BMO. Your line is now open.

Speaker 13

Afternoon. Thank you very much. And Peter

Speaker 2

and Keith, appreciate the slides.

Speaker 13

I did find 7 and 8 to be quite interesting and want to focus my question on that. And if you look at the amount of billings from Sassy 24%, is there and just any clarification on of that 24%, how much is SD WAN? And then if I look at the SecOps, really interesting that enterprise is 40% of the SecOps. And is there just any patterns or anything that's kind of bubbling up as a frequent purchase within the SecOps portfolio you have that is serving to be pretty interesting to the enterprise. I just I thought that 40% number was quite interesting.

Speaker 13

And believe it or not, I'm going to count that as one question. And then Keith, just anything you could think about or guide us on the FortiCare support line item as we think about the correlation to the product sales? And then I will cede the floor before Peter gets a chance to cut me off.

Speaker 3

I can go reverse one and cover FortiCare, FortiGuard. I think it's a great question. FortiCare, which is the traditional support offering, we talk about services being a lagging indicator. It's really what did you sell before and what revenue you're recognizing now. And what's important is that FortiCare is going to be more closely linked to more recent product sales, right, because you have fewer products to attach it.

Speaker 3

So you probably see a little more pressure on FortiCare there. FortiGuard, which is the security subscriptions, which can be bundled, but they can also now be a variety of SecOps solutions and SaaS solutions, is getting a fair amount of tailwind from those other two pillars. So you will start to see I think and have seen a little more divergence in the growth rates as it goes through the cycle that we own between FortiCare and FortiGuard. And then I'd say that FortiGuard actually has higher margins, if you will. And I think that

Speaker 2

we decided to call out in the

Speaker 3

prepared remarks that if you looked at the SaaS and SecOps business, which I'll just broadly call SaaS, not County FortiCare and FortiGuard and our software licenses, you're starting to see a company now that has a run rate of about $750,000,000 in say non hardware and non attached service contracts, which is pretty impressive, I think.

Speaker 2

I would say, since we only launched our own 4 d SaaS6 months ago, we see pretty strong growth. But also SD WAN has been there for a few years. So I have to say probably most majority, if not the most, SaaS is still more come from SD WAN, which is in the chart there. Maybe the better way to say is really look in the pipeline. So that's on Keith's script.

Speaker 2

He says over it's a unified SaaS, you probably pipeline grow like 45% and then the SSE pipeline growth over 150%. That's maybe a better indicator as pretty strong for the SaaS interest and also leverage our post SD WAN and the firewall market leading position there. So we do see a lot of customer adding the SASE, adding the SD WAN and convert some of them to the additional service, which would probably come up over 90% of our like the SaaS business right now. And there's also very strong interest from the customer right now. At the same time, some of the trial program like using the Forti WiFi AP as a hardware agent offers certain free SASE service.

Speaker 2

That's also what drive additional like a differentiated SaaS unified SaaS approach compared to the other competitor in the market, which we also believe will be driving quite a lot of SaaS business going forward. So that's what we that's also the reason we believe probably within a few quarter to a few year, we'll be the number one leader in the SASI market.

Speaker 1

Operator?

Operator

Thank you. And one moment for our next question. Our next question comes from Joseph Gallo of Jefferies. Your line is now open.

Speaker 10

Hey guys, thanks for the question and getting in here. A lot of cool stuff around AI at your conference. For 40AI, any early feedback? And how are we thinking about monetizing that and any impact to gross margins? And when can that benefit top line?

Speaker 10

Thanks.

Speaker 2

Yes, totally agree. There's a lot of interest in AI, fully AI. We're starting to apply more fully AI to different product, which are helping customer more efficiently manage their operation there. And that's also what drives the additional service, additional product sales there. I'd say it's still more in the early ramp up stage, but the interest is very, very high and we do see some benefit already.

Speaker 2

But how soon will be materialized?

Speaker 3

Yes. I think it's some more tactical responses to you. In general, we're charging for it separately. It's on the price list. It's additive to it.

Speaker 3

And you're going to really push my technical knowledge, maybe somebody here can help me out. But I think there's an LLM that the customer has to go out and buy their own in some cases to enable it. And then I would offer a really shameless plug. I really tell you, you should go look at our website and see the demo that was done at Accelerate with FortiAI. It was fantastic.

Speaker 3

Yes. No, we saw it live.

Speaker 10

Just a quick follow-up on, I really, really appreciate the time to register metric. It's really interesting. Was there any seasonality in that metric historically before or after firewall cycles? Just trying to better understand if we should expect to find a floor at 2019 levels or if there's a potential another leg down? Thanks.

Speaker 2

I think probably if I look back to 20, 30 years when there's a big attack in the space, then there drives some kind of a new function, then there's some rush by assumption, maybe impact some of that. Otherwise, it's pretty normal, I don't know, 7, 8 weeks, whatever customer to register. And then the last 2, 3 years, the supply chain already changed in that. Sometimes certain channel partners, certain distributor may try to have a little bit more inventory. And sometimes the customer, because it takes some time to deploy, they also try to order some extra inventory.

Speaker 2

But that's pretty much all normal now. If you place the order, you pretty much can get it delivered right away, no longer has a lead time anymore. So that's where we see the digestion pretty much is all over and is pretty back to normal in the current environment now.

Speaker 3

Yes. I think the chart itself actually goes all the way back to 2019 and you can see it by quarter there. Nothing jumps out of me in terms of seasonality by quarter that we really have a that have a call out to it.

Operator

This now concludes the question and answer session. I would now like to turn it back to Peter Salkowski for closing remarks.

Speaker 1

Thank you, Brianna. I'd like to thank everyone for joining today's call. Fortinet will be attending investor conference hosted by JPMorgan and Bank of America during the Q2. Fireside chat website webcast links will be posted on the Events and Presentations section of Fortinet's Investor Relations website. If you have any follow-up questions, please feel free to contact me.

Speaker 1

Have a great rest of your day. Thank you very much.

Operator

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

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Earnings Conference Call
Fortinet Q1 2024
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