UnitedHealth Group Q2 2024 Earnings Call Transcript

Quartr
Provided by Quartr
August 6, 2024

There are 12 speakers on the call.

Operator

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

Operator

Aaron?

Speaker 1

Thank you, and good afternoon, everyone. This is Aaron O'Vadia, Director of Investor Relations at Fortinet. I am pleased to welcome everyone to our call to discuss Fortinet's financial results for the Q2 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 COO. This is a live call that will be available for replay via webcast on our Investor Relations website.

Speaker 1

Penn will begin our call today by providing a high level perspective on our business. Keith will then review our financial and operating results Q2 of 2024 before providing guidance for the Q3 of 2024 and updating the full year. We will then open the call for questions. During the Q and A session, we ask that you please limit yourself to one question and then one follow-up question to allow others to participate. Before we begin, I'd like to remind everyone that is on today's call that 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.

Speaker 1

Please refer to our SEC filings and in particular the risk factors in our most recent Form 10 ks and Form 10 Q for more information. All forward looking statements reflect our opinions only as of the date of this presentation, and we undertake no obligation and specifically disclaim any obligation to update forward looking statements. Also, all references to financial metrics that we make 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 the presentation accompanying today's remarks, both of which are posted on our Investor Relations website. The 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.

Speaker 1

Lastly, all references to growth are on a year over year basis unless noticed otherwise. I will now turn the call over to Ken.

Speaker 2

Okay. Thank you, Erin, and thank you to everyone for joining our call. We are pleased with our strong execution in the Q2 as we successfully balanced growth and profitability. We achieved record operation margin, which increased 820 basis points to 35% and managed to building and revenue at the high end of the guidance range, reached our full year 2024 revenue and operation margin guidance, and we continue to invest for growth, gaining market share in secure networking and investing in fast growing unified chassis and secure operation market. Secure networking customers are increasingly recognized our FortiOS and FortiAC technology offering 5x to 10x better performance than our competitors while increasing security effectiveness and providing a low total cost of ownership.

Speaker 2

For over 20 years, we have been leading the shift to networking and security convergence and the industry's projection now indicates secure networking will surpass traditional network by 2026, 4 years earlier than previously anticipated. In the Q2, Unify SASE accounted for 23% of total billings, up one point. We expect our differentiated unified SASE offering to become the leader in the SASE market. We believe we are the only company that has built all the SASE functions organically in a single operation system. We have a converged networking and security stack, including our market leading SD WAN, ZTNA, Secure Web Gateway, CASB, firewall and many other innovations.

Speaker 2

Our Sachi offering provides flexible enforcement, delivering a better user experience while securing access to application on premise and in the cloud. Furthermore, we continue to build our own SaaS delivery infrastructure, including leverage of 40 ks technologies, providing us with a competitive long term cost advantage. As announced earlier today, we acquired NextDLP, a next generation cloud native SaaS data protection platform extending from endpoint to cloud. This will allow us to enter the standalone enterprise DLP market as well as integrate market results 40 SASE solution. We also recently improved our position in the Garden Magic Quadrant for single vendor SASE and are the only vendor included in all 5 of major network security Magic Quadrant, single vendor SASE, network firewall, SD WAN, secure service edge and enterprise wireless LAN infrastructure.

Speaker 2

Each of these solutions run on a single unified operating system FortiOS with AI powered FortiGuard secure service and unified management. AI driven secure op accounted for 10% of total billing in the 2nd quarter, up one point. Our comprehensive Secure Op portfolio backed by over a decade of AI experience offers broadest range of sensor and advanced analytics to continuous access activity to identify sign of cyber threats. 4 gs AI harness generative AI to turbocharge our platform and help security operation team make better informed decision and response to threats faster by the most complex task. 4 gs is available in FortiAnalyzer, FortiSim and FortiSue and will soon be available in other FortiSign products.

Speaker 2

And we believe that together our solution form 1 of the most comprehensive 4 stack cloud security solution available from a single vendor. Lacework's organically developed AI driven cloud native application protection platform will be combined with the power of Fortinet Security Fabric platform, ensuring broad protection across network, cloud and endpoint. This acquisition increased our total addressable market by 10,000,000,000 and add a team of talented engineer dedicated to cloud native security while also expanding our sales force that can sell the entire Fortinet portfolio of solutions. Yesterday, we announced several enhancement to Forten OT security platform, which already stand as the most comprehensive OT security platform on the market. Enhancement included new recognized appliance, advanced secure networking and secure operation capability and expanded partnership with leading OT vendors, reflecting Fortinet's commitment to security for the growing cyber physical system market.

Speaker 2

As further evidence of our innovation and commitment to excellence in OT, we recently earned prestigious Red Dot Product Design Award for a 40 gigabytes RAC 70 gs with new 5 gs modem. Fortinet was the only cybersecurity company to receive this recognition in an industry next generation firewall. 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. Keith?

Speaker 3

Thank you, Ken, and thank you, Aaron, and good afternoon, everyone. Let's start with the key highlights from the Q2. Overall, we are very pleased with our execution in the quarter. We achieved record gross and operating margins at 81.5% and 35.1% respectively, while delivering top line numbers at the high end of our guidance range. Revenue grew 11% as product revenue exceeded our expectations driven by robust software revenue growth and sequential hardware growth that more closely aligned with historical norms.

Speaker 3

We also added 6,300 new logos as we continue to invest in our channel partners. As you'll hear in a moment, we believe we are on a pace for another rule of 40 year. At the same time, we accelerated our investments in the fast growing unified SASE and security operation markets for the acquisitions of Lacework and Next DLP. Lacework strengthens our position in the high growth CNAP market and expands our total addressable market by $10,000,000,000 while next DLP improves our position in the standalone enterprise data loss prevention market. Combined, Fortinet will gain over 900 customers and talented sales and engineering teams.

Speaker 3

And I'll just pause here to offer a very warm welcome to team members from both companies. Continuing with our Q2 highlights, we have taken the lead in partnering with the U. S. Cybersecurity and Infrastructure Security Agency or CICEF through a Secure by Design pledge and are leading with our responsible transparency practices. We want to emphasize understand customer trust is paramount to our business.

Speaker 3

Our continued success across all customer segments in each of our three pillars represents 100 of 1000 of end customers testing and buying Fortinet security solutions. Simply stated, this is a significant scale advantage and a responsibility few others have and also offers customers validation at a very robust level. We are committed to responsible updates and deployment processes, supply chain controls, product security measures and transparency. Understand more about the proactive measures we take to safeguard our customers and our reputation, please visit our trust website at fortinet.com backslash trust. Looking at billings in more detail, total billings were consistent year over year at 1,540,000,000 dollars overcoming the headwind from the drawdown in backlog in the comparable quarter.

Speaker 3

At the same time, total bookings increased year over year and more importantly, the sequential growth rate approached pre COVID pre supply chain norms. Unified Sassy and SecOps delivered strong growth along with software, while product sales recovered more than expected. We continue to see significant progress from our investments in both pillars and saw strong pipeline growth of 45% for Unified Sassy and 18% for SecOps. Both pillars are gaining significant momentum within our installed base as over 90% of Unified Sassy and SecOps billings are coming from existing customers. Larger Enterprises continue to be our largest customer segment, with large and mid enterprises combining to represent 86% 82% of Unified Sassy and SecOps solutions respectively.

Speaker 3

Within Unified Sassy, 40 Sassy buildings continue to grow at triple digit rates as existing customers can seamlessly integrate our solution within minutes to secure their hybrid workforce. While 40 client customers are able to use a single agent to secure Internet, private and SaaS applications. We've also integrated 40AP with 40 SaaSie for securing thin edges and unmanaged devices. Our unified Sassy solution continues to gain market recognition. For the 2nd consecutive year, we've been recognized as a challenger in the Garden Magic Quadrant for single vendor Sassy with the 3rd highest placement in the ability to execute access.

Speaker 3

And as mentioned earlier, we are further improving our Forti SASE solution by adding powerful data loss prevention capabilities from Next DLP. Rounding out the billings commentary, SMB was again the top performing customer segment, while international emerging was again our best performing geography. On an industry vertical basis, technology and transportation grew at double digit rates, while service provider and manufacturing were more challenged. Turning to revenue and margins. Total revenue grew 11% to $1,434,000,000 dollars driven by service revenue growth and software licenses.

Speaker 3

Service revenue of $982,000,000 grew 20%, accounting for 68.5 percent of total revenue. Service revenue growth was led by 36% growth in SecOps and 27% growth in Unified Sassy. As noted on Slide 5, Unified Sassy includes SSE and related technologies together with SD WAN. Product revenue decreased 4%, but better than expected to $452,000,000 Excluding the impact of backlog, product sales growth improved 14 points quarter over quarter and a similar amount year over year. Software license revenue growth continued to accelerate at 26% and represented a high teens percentage of product revenue, a nearly 5 point increase in the software mix year over year.

Speaker 3

Combined revenue from software licenses and software services such as cloud and SaaS security solutions increased 32%, accelerating from 23% a year ago and providing an annual revenue run rate of over $800,000,000 Total gross margin increased 360 basis points to a quarterly record of 81.5 percent and exceeded the high end of our guidance range by 400 basis points, benefiting from higher product

Speaker 4

and services gross margin as well as

Speaker 3

a 5 point mix shift to higher margin service revenues. Product gross margin of 66% increased 2 50 basis points year over year, mainly due to increased software mix and lower indirect costs. On a quarter over quarter basis, product gross margin increased from 56% to 66% as hardware demand increased and inventory levels and related inventory charges moved closer to historical norms. Service gross margin of 88.6 percent increased 2 40 basis points as service revenue growth outpaced labor cost increases

Speaker 2

and benefited

Speaker 3

from the mix shift towards higher margin FortiGuard security subscription services. Operating margin increased 820 basis points to a quarterly record of 35.1 percent and was 840 basis points above the high end of our guidance range reflecting the record gross margin as well as cost efficiencies within the business. Looking at the statement of cash flows summarized on Slide 16 17, free cash flow was $319,000,000 for the quarter $927,000,000 for the first half of twenty twenty four or $1,100,000,000 after adjusting for real estate and infrastructure investments. Cash taxes in the quarter were $252,000,000 As a reminder, last year's Q2 benefited from the deferral of approximately $190,000,000 in cash tax payments, which were ultimately paid in the Q4 of 2023. Infrastructure investments totaled $23,000,000 Average contract term in the Q2 was 28 months, flat year over year and up 1 month quarter over quarter.

Speaker 3

DSO decreased 7 days year over year and increased 2 days quarter over quarter to 68 days. While we did not repurchase shares in Q2, share buybacks have totaled $5,300,000,000 over the last 4 plus years and the remaining buyback authorization is $1,000,000,000 Now I'd like to share a few significant wins from the Q2. In a 7 figure deal, an international government agency purchased 12 solutions across all three pillars, including 8 SecOps solutions. This new customer selected Fortinet because of our operating system's ability to consolidate over 30 networking and security functions into a single unified platform covering SecOps, SASE and Secure Networking. The customer was impressed with the integrated security end to end visibility and automated response features of our FortiOS operating system.

Speaker 3

Next, in a 7 figure win, a large utility company expanded our partnership by signing their first enterprise agreement with us to safeguard their OT environment. This deal displaces 5 legacy vendors and includes ruggedized equipment deployed at the customer's power plants, control centers and substations.

Speaker 4

Keys to

Speaker 3

this expansion win were our proven expertise in securing critical infrastructure and our price for performance advantage. And lastly, in a competitive displacement win, our retail store chain purchased our FortiSassy solution in a 7 figure deal. This customer chose Fortinet because of our integrated FortiSASE platform as they were able to seamlessly integrate FortiSASE with their existing Fortinet security solutions. Now I'd like to offer some comments on customer inventory digestion and the firewall refresh cycle. Last quarter, we pointed to a 25% improvement in the number of days to register FortiGuard contracts from its peak and view this as an early, but soft indicator that inventory digestion at end users appear to be normalizing and the firewall market could start to show signs of recovery.

Speaker 3

To provide an update on this indicator and other signs of possible improvement in the firewall market, we can share that as shown on Slide 19 in the Q2, the days of registered security service contracts improved another 12 days and has now returned to 2020 pre supply chain pre COVID crisis levels. Inventory commitments and levels are normalizing at our contract manufacturers and in the channel. And as noted earlier, the sequential increase in hardware sales in the 2nd quarter aligned more closely with historical norms. While these indicators are positive, we believe customers are currently managing a tough macro environment in a key election year in the U. S.

Speaker 3

And we believe this is having an impact on our customers' purchasing decisions. As a result, we believe a full refresh cycle is unlikely to occur in 2024, but more likely in 2025. Moving on to guidance. As a reminder, our Q3 and full year outlook, which are summarized on slides 21 and 22, is subject to the disclaimers regarding forward looking information that Aaron provided at the beginning of the call. Before we view on the outlook, I'd like to offer a few modeling notes in light of our lacework and NEX DLP acquisitions, covering estimates included in our Q3 and full year guidance.

Speaker 3

For billings, the acquisitions increased Q3 by approximately 1 half point and the full year by approximately 1 third point. Total revenue increased Q3 and full year growth by 1 point and 1 half point respectively. For gross margin, they decreased Q3 and full year margins by less than 1 half of a point for each period. For operating margin, they decreased Q3 and full year margins by 3 points and 1.5 points respectively. Inclusive of these acquisition related estimates, for the Q3 we expect buildings in the range of 1,530,000,000 dollars to $1,600,000,000 which at a midpoint represents growth of 5%.

Speaker 3

We're running in the range of 1,445,000,000 dollars to $1,505,000,000 which at the midpoint represents growth of 10.5 percent. Non GAAP gross margin of 79% to 80% non GAAP operating margin of 30.5% to 31.5 percent Non GAAP earnings per share are $0.56 to $0.58 which assumes a share count of between $767,000,000 777,000,000 capital expenditures of $40,000,000 to $60,000,000 a non GAAP tax rate of 17% and cash taxes of $125,000,000 to 145,000,000 dollars And again, for the full year, inclusive of the numbers we gave a moment ago, we expect billings in the range of $6,400,000,000 to $6,600,000,000 revenue in the range of $5,800,000,000 to 5,900,000,000 dollars which at the midpoint represents growth of 10%. Service revenue in the range of $3,975,000,000 to $4,025,000,000 which at the midpoint represents growth of 18%. Non GAAP gross margin of 79% to 80% non GAAP operating margin of 30% to 31.5 percent non GAAP earnings per share of $2.13 to $2.19 which assumes a share count of between $767,000,000 777,000,000 dollars Capital expenditures of $320,000,000 to $360,000,000 non GAAP tax rate of 17% and cash taxes of between $525,000,000 $575,000,000 I look forward to updating you on our progress in coming quarters.

Speaker 3

Before we begin the Q and A session, it is with deep sadness that we recognize the passing of our friend Peter Salkowski, our SVP of Finance and Investor Relations. Peter was an integral part of the Fortinet team for over 6 years and was renowned for his passion for mentoring and developing the next generation of leaders. We'll miss Peter and fondly remember his commitment to fostering talent and nurturing potential within our company. I know that Peter worked closely with many of you on this call and the outpouring of condolences and heartfelt memories you've shared since his passing clearly shows the positive impact he has on so many people's lives. Peter took great pride in his contribution to Fortinet and rightly so, having contributed to increasing shareholder value from $8,000,000,000 to $46,000,000,000 during his tenure at Fortinet.

Speaker 3

We'll miss Peter. Aaron, back to you.

Speaker 1

Thank you, Keith. As a reminder, during the Q and A session, Operator, please open 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 Brian Essex of JPMorgan. Your line is now open.

Speaker 5

Great. Thank you very much for taking the question. And obviously, sorry for your loss. Keith, if I could maybe touch on the margins, I think it's incredible margin results for the quarter. Could you help me understand or maybe unpack outside of the obviously the gross margin benefit that you saw in the quarter, Maybe help me understand where you saw better cost efficiencies?

Speaker 5

How sustainable are they, particularly in light of the effort to incentivize the channel and the sales force to focus more on selling SecOps and Sassy with maybe some incremental effort?

Speaker 3

Yes. I think the gross margin is the largest driver of what you saw in the operating margin, particularly when you look at it on a quarter over quarter basis. And in that, we talked about or made reference to a more normalized environment for us in terms of inventory levels, turns and what we're seeing with channel inventory, but also commitments to our contract manufacturers. So I think that we've been working through that for probably the last 3 quarters, maybe 4 quarters. And with that, I would say, I think we've returned to a more normal state.

Speaker 3

And so I would expect that to continue on. I think we're getting a little more contribution from sales and marketing than maybe I'd like at the moment. And I would expect us to make a little bit more investments there as we go through the second half of the year. Keep in mind, we're getting a very large group of sales people as Ken made reference to from both the Lacework and the NEX DLP acquisitions. But I think we feel certainly comfortable with the guidance that we've given for both Q3 and for the full year on the margin line.

Speaker 5

Great. Maybe just a quick follow-up, how should we anticipate the impact of the operating margin to reflect on free cash flow as we look through the rest of the year? Should we look at historical spread between margin and cash flow margin and maybe estimate kind of ballpark the same kind of spread or are there going to be more puts and takes like timing of tax payments that are going to mess with that free cash flow margin as we fine tune our models? Thanks.

Speaker 3

Yes. I don't I mean, I think that's a good starting point is to look at the improvement in operating margin flowing through to free cash flow. Some of the changes that we monitor would be things like contract duration, but you've seen now that industries and companies have been talking about contract duration for several quarters and you really haven't seen that come through to us yet. I shouldn't say yes, it hasn't really come through to us. And so I'm not I think we have opportunity to leverage our balance sheet more with our customers and prospects than we have.

Speaker 3

But I don't see over the next 90 days or 180 days a dramatic shift in that area.

Operator

Our next question. Our next question comes from the line of Hamzah Fodderwala of Morgan Stanley. Your line is now open.

Speaker 6

Good evening. Thank you for taking my question and echo my condolences for Peter and his family. We'll definitely miss him. Keith, I wanted to follow-up on the margin question because obviously it was a very strong beat. I think a lot more than any of us were expecting.

Speaker 6

Historically, Fortinet has kind of managed the business towards this 25% plus type operating margin run rate. I'm curious, is this the new base that we should sort of think Fortinet goes off of longer term

Speaker 3

or is it

Speaker 6

sort of a one time margin outperformance given what you saw on the gross margin side coming out of the inventory digestion headwinds? Thank you.

Speaker 3

Yes. Again, I think the inventory part of that is I think we've worked our way back to a more normalized state. So I think that is our business model going forward, put it that way. There can always be something that changes, but I don't see us anticipating something in the gross margin line and that is by far and away the biggest opportunity there. I think it also says that we clearly have the opportunity to more invest more in go to market than we did in the first half of this year.

Speaker 3

And I think we've factored in some of that investment ideas or those ideas in our forecast and our guidance. In terms of whether or not I make Ken cry when I increase the margin the way I did, that's a different topic and I'll let him respond to that.

Speaker 2

Also, we're benefiting from the service revenue, which has a much higher margin compared with the product revenue. So once the product started growing, because product has a lower gross margin, that's probably what impact the margin. But the product is also the leading indicator of future service. So that's where we kind of also be happy to see the product starting also starting growing now, which I think going forward with the product has a higher percentage, that probably also will impact the margin.

Speaker 3

Makes sense. Thank you.

Speaker 2

Thank you.

Operator

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

Speaker 7

Thank you for taking my questions and I wanted to share my condolences for Peter. He was just a fantastic person and he will absolutely be missed. Keith, I wanted to 0 in on your comments regarding software license growth. You talked about that accelerating 26% year on year, I believe, and now it constitutes a high teens percentage of your product revenues. I wanted to understand what are the drivers behind that massive mix shift and how we should think about the trajectory of this mix shift in the context of your guidance for the remainder of the year and bringing into consideration, some of the hardware digestion, potential prolonging comments that you shared as if you can help us square that away?

Speaker 7

Thanks.

Speaker 3

Yes. I think the software license, if you kind of step back and look at what the business model is, not to make it overly simplistic, we want to it's so compelling to start with a firewall. And it's very compelling to start with the ASIC. So a physical part of it. We don't always do that, but we almost always start with a firewall, whether it's physical or virtual.

Speaker 3

Really what you want to do is get the operating system in the hands of the customer. And what form factor that takes is we're fairly agnostic about that. But once that happens then you start to see the knock on effect of either selling more firewall use cases and other form factors into organizations or you're seeing that full portfolio of the SecOps product line take hold as it continues to expand throughout organization. So I would expect that we're going to continue to see tailwinds and growth, no doubt about it from the software part of the business. Will there be a mix shift that slows a little bit when firewall and FortiGate starts to return?

Speaker 3

Sure, absolutely. But this has been a trend that we've talked about a little bit I think last quarter and probably some earlier quarters about the software mix and the mix shift that we've been seeing. So I would expect that that's going to continue on given the success we're seeing in the other two pillars.

Speaker 2

Yes. In the FortiGate, FortiOS, we see customers that internal more and more function, which also enable more service for us. And at the same time, the Forti SaaS is secure up has also pretty much all service base and plus a lot of Secure Op. Secure Op has higher percentage in the software compared to the hardware on the secure networking part. So that's both helping drive the additional software and licensing growth.

Speaker 7

Thank you very much. Very clear.

Operator

Thank you. One moment for our next question. Our next question comes from the line of Gabriela Borges of Goldman Sachs. Your line is now open. Good afternoon.

Operator

Thanks for taking the question. Either for Ken or for Keith, on the silo refresh cycle, I can appreciate your comments on not expecting to see a recovery in 2024. Share us a little bit more detail on why you think we'll see it in 2025. To what extent are customers giving you an indication that they will be refreshing in 2025, perhaps as we get through the election and some of the macro or perhaps because of their updated depreciation plans? Any color on why you think the timing will be 2025 would be helpful?

Operator

Thanks.

Speaker 2

I think it's probably more Keith's comment. I think the rest of the year probably still pretty tough, like an environment where the election or some interest rate is still pretty high, the money cost is still pretty high. That's where some company may not really want to spend some long term investment, which is drive the product revenue and building infrastructure. So that's what we feel. Also, if you look at historically, every 4 years or 4 to 5 years, the network gear, whether network and network security, they need to be refreshed for faster, more function there.

Speaker 2

So that's where we feel when we're starting this supply chain issue, they artificially push up the since like starting 2,001. Maybe next year will be pretty much full year cycle now. So some company may start looking to refresh the product they purchased 4, 5 years ago, especially in certain vertical like retail, some other, we see pretty strong growth in early days of a supply chain issue. And we feel probably in the next 1 to 2 years, they may start in return to see some investment on their infrastructure. On the other side, we see the big trend we always believe, always a hybrid mode.

Speaker 2

Even there's a like we have a very advanced SaaS infrastructure side, but also to secure OT, IoT area to secure a lot of infrastructure work from home and we do need appliance in the field. And also even for SASE, we do offer both the cloud based SASE and also on premise based private SASE. So that's also needed some power to supporting locally for the customer.

Operator

Thank you. And our condolences to the team as well.

Speaker 2

Thank you.

Operator

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

Speaker 8

Hi, guys. The fact that can you go back to the fact that billings, you made 2 acquisitions this quarter, you didn't change the billing guidance for the year, but you did beat the numbers for this quarter by $20,000,000 So in effect, you reduced the billing for the next two quarters. What are the drivers in billings? I know we spoke about it in the past, but what are the drivers for billings? And what's the outlook for billings going forward?

Speaker 8

Second question is your you grew revenues by 11%, but when you look at OpEx, they're flat. And you don't do buybacks now. What's the outlook for buybacks? And what's the outlook for OpEx? Will it start growing now that you started executing on revenue growth?

Speaker 8

Thanks.

Speaker 3

Tal, I think I kind of missed you're very, very faint on your questions. So maybe if you can give us maybe a little louder recap of the two questions you had.

Speaker 2

I think I touched some part about the 2 acquisitions impact on building. I believe that Bose acquisition, I think it's Lacework maybe this year will contribute maybe in the 2020.

Speaker 3

Yes, I think that mean, if you kind of look at the recap of the year, there's not a lot of variability in it, if you will. We were a little bit light in the Q1. We came back and recovered the Q1 shortage in the Q2. Now you see us looking at the Q3 and maybe taking that just a little bit off of some of the Street numbers and looking to see a little bit of that back in the Q4. But we're kind of taking the 3rd quarter correction to the Street numbers and putting it into the full year number.

Speaker 3

But yes, offsetting a very, very similar amount in terms of what we expect to get from the acquisitions. And that leaves the full year range very much intact. And I understand that to cut the quick, I understand part of that is I'm taking I'm getting inorganic benefit in that number of the half point that we talked about at the and really taking down the organic part of the business. But again, I think we're talking about small numbers here.

Speaker 8

Got it. My second question, if you can hear me okay now, but my second question was about OpEx that was flat and no buybacks. What's the outlook on those items?

Speaker 3

Yes. I think the OpEx probably a little lighter on the sales and marketing line than maybe we would like to see, particularly as we start looking at more opportunities as we get into the second half of the year and into 2025. So hopefully we'll find some opportunities there to make investments. Obviously, you're going to get a fairly significant movement there from the 2 acquisitions that we just did and we gave the number about what the OpEx impact is going to be that will largely be in sales and marketing. Buyback, I think that we still remain being opportunistic and that opportunistic number changes every 90 days as we reset our plans.

Speaker 2

Yes. And also in the market, whether the private company, public company, we see the multiple probably more friendly for merchandising now compared to the last 2, 3 years. So, ratio go back to more reasonable, so that we see some opportunity there.

Speaker 1

Great. Thank you.

Operator

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

Speaker 9

Yes. Thank you guys for taking my question. Curious relative to the macro and obviously a lot of crosscurrents out there, maybe what you're seeing via your different customer sizes and different theaters? Thanks.

Speaker 3

Yes. I think because we are so diversified as you kind of alluded to it, 70% of the business is international and a little bit less than 30% in the U. S. And yes, there's been a lot of elections around the world this year, but it's certainly the U. S.

Speaker 3

Election maybe weighing on people and every kind of taking a position of waiting to see. As you move pull back from that, the international emerging part of the business has been strong, very strong for several quarters and continues on to be so. A lot of those are oil producing countries and similar. So I think they've done well in this economic cycle. There are a little more risk there perhaps with geopolitical events in some of those countries.

Speaker 3

But to this point, it really hasn't had an impact there. We are much more likely to be the have the number one market share when you move outside the U. S. And parts of Europe and the Middle East and Latin America and parts of APAC. And I think having an incumbency advantage, if you will, helps you in those more challenging times because you're there, you're on-site and you have that opportunity to cross sell and up sell your installed base.

Speaker 2

Yes. In the U. S, that's the next growing area, which also need more direct marketing, direct sales. That's also need more investment. So that's what we do plan to invest more into sales and marketing to keep gaining market share in the U.

Speaker 2

S.

Speaker 9

And Keith, as you contemplate these acquisitions and a little bit of mix shift to software, and I realize hardware is weak right now with a potential recovery next year. But how are you thinking about billings duration? You shave some off the back half, and I think some of that's probably the mix shift towards software as we kind of look overall at the model and the increase in revenue. But as we contemplate 2025, how should we think about billings duration and potential compression with more cloud based or software deals that are likely shorter in nature?

Speaker 3

Well, I look forward to seeing you in November at the Analyst Day when we'll talk more about 2025 and midterm numbers. But in the interim, I would probably say that if it's a white space account in some of these places like Lacework would be for example, I think it's going to be much more prone to having a shorter duration contract. If it's part of that 90% of me selling SecOps or SaaS solutions to my installed base, what I'm seeing to this point is my installed base continues to purchase in terms of contact duration the way they have historically. So they haven't if I sell something from the Secop portfolio into one of my firewall customers, they tend to sign up for a longer duration contract than you may see from a point solution vendor.

Speaker 9

Great. Thanks. Thoughts are with you and the team. Thank you.

Operator

Thank you. One moment for our next question. Our next question comes from the line of Shaul Eyal of TD Cowen. Your line is now open.

Speaker 10

Thank you. Hi, good afternoon, everybody. Keith or Ken, so listening to Keith's commentary about that potential refresh cycle not taking place in the second half of this year, but most likely during 2025. And again, not trying to front run the November Analyst Day, but should we be thinking about 2025 accelerating over 2024? And again, I know maybe you don't have the current visibility to guide to 2025, but just conceptually, is it fair to assume another year of double digit growth?

Speaker 2

We do believe next year there's I think, 1st overall, we see the long term convergence, networking converge to network security we're still keeping going. And that's why we do give the CAGR in secure networking areas about 15% year over year growth. If you look in the investor presentation slide there, I forgot which page.

Speaker 3

But on

Speaker 2

the other side, also see a lot of new opportunity, whether in the OT area in the unified SaaS and also upsell, cross sell, which all help in driving, I have to say, probably like 90% of customer initially move by our FortiGate getting the firewall and network security market first, which we have a huge advantage over competitor. But after that one, they keep expanding beyond that network security go to the other area. So that's what happening for the unified SASE, for the SecureOp. And now the product, especially on the FortiGate firewall side, we're starting to see kind of go back to normal starting growing with the market now. So we do feel probably next year will be whether the refresh cycle, which after that's where the existing customer, if they have the product for 4, 5 years, that's probably the average term they starting to refresh.

Speaker 2

And so we do see probably next year we're starting up that process.

Speaker 5

Got it. Thank you.

Operator

Thank you. One moment for our next question. Our next question comes from the line of Brad Zelnick of Deutsche Bank. Your line is now open.

Speaker 5

Great. Thanks so much for taking the question. Keith, I think you called out the service provider segment is more challenged this quarter after being a strong performer last quarter. And I know it's lumpy and remains a top vertical as it always has been performing it. But can you share an update on what's happening in that segment?

Speaker 5

And in particular, how your value prop and focus on unified SaaS and SecOps supplies in this important vertical?

Speaker 2

Yes. I don't feel the service provider telecom slowdown. It's really kind of lumpy. And on the other side, we also starting to see the telecom service provider more interest in offer their own SaaS using our product solution or kind of helping customer do the private SaaS, localized SaaS, which also will help in drive our long term growth. But I do believe long term wise, the service provider will be still the big, if not the biggest, probably one of the biggest part of the whole cybersecurity business because they have the infrastructure, they have the customer relation.

Speaker 2

So we still want to keep in focus on the service provider area. But for them, as well as the sales cycle relatively long and the deal pretty big, usually like 8 figure deal. That's what the lumpiness probably impact the quarterly. But if you look at more long term, multi quarter annually, I do believe it's still keeping growing.

Speaker 3

Yes. Ken is spot on, right? It's a lumpy industry. Financial services can be too at times as well. But I think more importantly, I think the conversations around their own independent SaaS solution that they can bring to market is something that's getting a lot more conversation from the service providers.

Speaker 3

I think we saw it 1st internationally and we're starting to see a little bit more of it here domestically. But that's going to that's a pretty exciting opportunity that continues to move forward.

Speaker 2

Thanks Keith and thanks Ken.

Speaker 5

Just a quick follow-up on the very impressive operating leverage that you've shown us, particularly on the sales and marketing line where I know, Keith, you said that it's more than you'd like to see at this point. But just structurally, like to see it down, albeit very slightly sequentially on a dollar basis, especially as you outperformed on the top line and billings this quarter, I'm just trying to understand like where it comes from? And is there anything structurally that changed that we should be thinking about, whether it's commission deferral rates, channel rebates or anything else, other than headcount? Thanks.

Speaker 4

Yes. I think there's

Speaker 3

a few things going on there. I think probably 9 months ago, we looked at the cost structure pretty closely and across a number of areas. And the first place that people kind of look at and when you're in that boat is marketing programs and they get hit pretty hard early on. And I think you kind of see that roll through. You do make changes to your compensation programs whether it's for direct salespeople or for channel people or what have you.

Speaker 3

And I think maybe as we're coming out of that environment now, it's important for us to kind of revisit some of those decisions and making sure that kind of talk about the investment opportunities that we have in the sales and marketing line. And I think I would include the channel net as well. It is why I would say that to your point or you're repeating me, probably a

Speaker 6

little bit lower than we

Speaker 3

would have liked it to have been in the Q2. And I think we'll continue to make go to market investments here in the second half of the year.

Speaker 2

Yes, I agree with Keith. We're starting tracking more carefully for the ROI for each investment in marketing sales and also try to improving the efficiency with the marketing and sales. On the other side, we are a little bit behind on hiring in the sales marketing side, which we intend to accelerate. So that's actually what will drive the future growth.

Speaker 5

Thanks very much guys.

Speaker 2

Thank you.

Operator

Thank you. One moment for our next question. Our next question comes from the line of Adam Tindle of Raymond James. Your line is now open.

Speaker 5

Okay. Thank you. I just wanted to continue the margin discussion. Obviously, you had great product gross margin performance this quarter on top of those tight cost controls. And the question really is around pricing dynamics in the core firewall business from here.

Speaker 5

The supply chain sounds like it's clearly normalized. You've had multiple years of price increases during this period of time. What are your expectations of the pricing dynamic in core firewall from here? What would it take to maybe even consider reducing price back to historical at some point? And any comments that you want to make on the competitive environment in light of this?

Speaker 5

Thank you.

Speaker 2

I think we have not increased the price in the last few quarters. I think that because we still believe we have a huge advantage with our 40 ASIC, 40OS technology has a more function, better performance, lower total cost of ownership and also energy costs. So we feel we're keeping that advantage over our competitors. On the other side, we don't see any pressure to also decrease price or kind of a discount more. So that's where we feel we're keeping pretty stable for the price and at the same time let the customer see the benefit of our product and solution and with better performance, more function, which also would drive the future service.

Speaker 2

I think the bigger environment also we don't feel changed much. Definitely, we see the inventory all go back to normal weather in our own kind of inventory and also the channel inventory. That's also more helping driving the healthy behavior in the business, also in the supply chain area. Can you please add some color?

Speaker 3

Just to repeat what Ken said, maybe with a more granularity. I think the price increases that you referred to were really probably up late 2021, 2022 impact. And I don't think we're really raising prices at 2023. We did take some prices down at the end of 2023 and in the very beginning of 2024. But that's really been the only pricing actions we've noted we've taken in the last 6 months.

Speaker 3

And then to Ken's point, I think we're at a moment where we think it's probably the value for the solution is very, very strong. I think the energy cost that Ken mentioned is starting to get it's gotten a lot of traction internationally in Europe, but you're starting to see more conversation around that in the U. S. And that could be people concerned about energy consumption and issues with AI and EV and government actions on manufacturing. So I do think the energy cost advantage is coming into play more.

Speaker 3

And then last one on that, discounting was I think very much in line. I think we actually improved quote unquote improved discounting meaning higher prices by about a point quarter over quarter and kind of a similar number one way or the other for the full year. So we obviously have room given the margins to use discounting and pricing as a lever. But I think there's other things that we'd like to push on first.

Speaker 2

Makes sense. Thank you.

Operator

Thank you. One moment for our next question. Our next question comes from the line of Adam Borg of Stifel. Your line is now open.

Speaker 5

Awesome. Thanks for taking the question. And also the condolences on Peter's passing. He certainly missed all of us. We'd love to talk about the NextDLP acquisition.

Speaker 5

Maybe talk a little bit more about what's attracting you to the standalone and NextDLP in particular?

Speaker 4

Yes, thanks for the question. This is John Whittle. There's a lot of positivity around that. We obviously just announced it today and we closed it yesterday.

Speaker 3

We did a lot

Speaker 4

of diligence on the company. The tech is great. And not only will we plan to offer it standalone, but also integrated with our FortisSASE solution. And so I think it's another step in steadily bolstering our FortisSASE solution. We feel very, very confident in our strategy there.

Speaker 4

For the most part, as you know, I mean, we've done some tech in talent, tech ins. Most of our technology is organic. I think to some of the earlier questions, you think about the firewall market coming back next year and we really just started kind of organizing our solutions into these three pillars less than a year ago. And the amount of progress we made and the execution we've made in kind of developing very, very competitive solutions in SaaS and SecOps in addition to secure networking is pretty impressive. And I think this is an important step along the way to continue to develop the best SASE solution out there to protect our customers.

Speaker 5

That's great. And maybe just as a quick follow-up there, John, maybe just could you comment on current levels of sales force productivity for SaaS and SecOps and the opportunities for improvement from here? Thanks again.

Speaker 4

Sorry, the sales execution with SaaS and SecOps?

Speaker 5

Just general sales force productivity as you've gone through many months this point of training and just ramping of the ability to sell that across your company globally?

Speaker 4

Yes. No, it's a really good question. I think what we're seeing is it does take time. We are very focused on that broad sales enablement. I always say, I mean, the opportunity just abounds from our solution set and we're always with this customer first focus.

Speaker 4

So in terms of protecting and serving our customers, the opportunity abounds. I think our sales force the good news is they have a ton of opportunity. I always say they're going to suffer more from indigestion than starvation, but we've got a really a big focus in the company to really train up that sales force, enable that sales force, make sure we have the incentives in the right place and make sure we have the support. So when they do qualify different opportunities in our different solution sets, we have the support to support them in that sale. So I think like Keith had alluded to, we often land with the firewall and then expand and give that support to our sales force with SASE and SecOps solutions and

Operator

Our next question comes from

Speaker 5

the line of

Operator

Our next question comes from the line of Saket Kalia of Barclays. Your line is now open.

Speaker 11

Okay, great guys. Thanks for taking my questions here and tip my cap to Peter as well. We're going to miss him. Ken, maybe just to start with you, I wanted to get into just the firewall refresh for next year a little bit. I mean, you've seen so many refresh cycles over the years.

Speaker 11

How would you sort of compare this upcoming cycle versus others in the past? And maybe touch on how Sassy and sort of maybe what sounds like a higher mix of virtual might sort of play into that?

Speaker 2

Yes, I agree. There's the infrastructure probably different than the last refresh cycle. You see more hybrid working environment, whether working remotely and also most supporting broad connection, including connect all this OT IoT device level. For the SASE, we always believe also should be a hybrid SASE environment, not just cloud only. You do need to have a private SASE, some other local SASE offer by service provider and also sometimes the SaaS also need to secure some device which cannot install the software agent like using our 40AP, 40 switch to select release agentless device.

Speaker 2

So that's where we feel this also will always kind of the unified SaaS will be the long term future we believe, which also combine both the hardware and the software and infrastructure and appliance together. So that's where the refresh. On the other side, network security always probably the biggest market. I mean, it has been the biggest market in the cybersecurity for probably 30 years now, 20, 30 years. And keep expanding because more people device get connected more application to access how to even access the cloud, you do need to secure on the network side.

Speaker 2

So that's what we see when you try to access the network side and also the long term convergence of network and network security, that's also what drives the refresh. That's also you can see the Gartner research we point out the convergence of networking and network security also starting to accelerate in. So originally, I think last year they say by 2,030 the secure networking will be larger than traditional networking. Now they say 2026, 4 years ahead, the secure networking will be larger than the traditional networking. So that's where we really invest long term on this trend and with all this FortiOS, Forti ASIC and making the best both our plans and infrastructure, the ASIC OS technology and at the same time also try to invest more in the sales marketing area to really catch the trend and also keeping gaining market share.

Speaker 2

So that's the strategy we have. That makes a lot of sense. Keith, if

Speaker 11

I could fit in one quick follow-up. Just on the software mix in product, I think you said, call it, roughly $800,000,000 run rate. Can we just touch on, even anecdotally, roughly how much of that is sort of virtual firewall versus SecOps? And I realize they're coming in at software gross margins, but can you put a finer point on that and sort of what that aggregate business might be coming in at from a gross margin perspective as we think about that gross margin shift long term?

Speaker 3

Well, I think whether it's a virtual firewall or any other software product or the software licenses are all coming in at very, very attractive margins. I think that when you look at some of the SaaS solutions that are sitting in the services line for SecOps and so forth, you get a very wide range of margins there, but it's only because of the relative size of maturity of the solution. Obviously, something is very new and absorbing a lot of the hosting costs is a little harder, but those aren't big as big numbers. As you see those SecOps solutions get greater and greater traction and more critical mass, the margins start to normalize. I think kind of what's really been exciting is the ability to absorb those data center, PoP, colo, everybody's got their hand in the pocket on these things, cloud provider fees in developing the SaaS solutions and still bring up the services gross margin.

Speaker 3

And by the same token, being able to absorb the charge for lace work on the operating margin line, because we've managed the business in terms of cost of goods sold for the product side. I think we're really, really pleased with how those two things have worked hand in hand.

Speaker 11

Absolutely. It shows. Thanks very much.

Operator

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

Speaker 5

Hi, thanks for the question. I also want to echo my condolences to the team and Peter Stanley, big shoes to fill. I just wanted to double click on what drove the better performance in product in 2Q. Was there some large deals or region segment or vertical that stood out, especially since you don't expect the refresh benefit until No. Which calendar is like that?

Speaker 3

Dive? No, great question. I mean, we've talked about 8 figure deals and at our size 8 figure deals can kind of still whips off around as you saw in the Q4 last year when we did 6 of them. We had 1 6 figure 8 figure deal Q1, we had 2 in Q2. So I really wouldn't attribute it to that.

Speaker 3

I think that yes, I think what we saw the last month of the quarter, particularly as we got into the last week of the quarter, what you see in a strong market is a lot of deals started to fall in place and getting across the finish line. I think we saw a lot more positiveness if you will at the end of Q2 than maybe we saw at the end of Q3 or something like that last year.

Speaker 2

Okay. Thanks. And then just on

Speaker 5

a follow-up to that, and I think it was a follow-up to Fatima's question. Given that mix shift you now expect in the second half given the delayed refresh, what is your confidence or visibility into the billings reacceleration in the second half? Do you in theory have more visibility now given that it's less hardware based or how are you thinking about that? Thank you.

Speaker 3

Yes. I don't think that the form factor really impacts the visibility in terms of what's in the pipeline or how we work with the sales teams in terms of forecasting. I've not noticed a difference if you will in close rates between a virtual machine and a physical machine.

Speaker 2

Yes. We probably would do some more deep study to maybe Analyst Day will give some color next year and also some midterm model in November 2018, which also the 15th anniversary of IPO.

Speaker 5

Thank you.

Speaker 2

Thank you. Thank you.

Operator

Thank you. This concludes the question and answer session. I would now like to turn it back to Aaron O'Vegia, Director of Investor Relations.

Speaker 1

Thank you. I'd like to thank everyone for joining today's call. Fortinet will be attending investor conferences hosted by Deutsche Bank, Goldman Sachs and Oppenheimer during the Q3. We will also be holding an Analyst Day on November 18, where we expect to update our medium term financial model. The webcast links will be posted on the Events and Presentations section of Fortinet's Investor Relations website.

Speaker 1

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

Operator

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

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