Fortinet Q2 2022 Earnings Call Transcript

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August 2, 2022

Key Takeaways

  • Strong Q2 growth: Total billings grew 36% year-over-year to $1.3 billion and revenue hit $1.03 billion, up 29%, driven by 34% product revenue growth and robust SD-WAN (+60%) and OT (+75%) bookings.
  • Fortinet debuted the FortiGate 4800F, touted as the world's fastest compact firewall for hyperscale data centers and 5G networks, offering 5–10× higher performance than competing solutions.
  • Service revenue faced temporary headwinds from suspending Russian contracts, delayed activations, and shipment timing, but earlier pricing actions offset these and service growth is expected to accelerate in H2.
  • Backlog rose to $350 million, up $72 million sequentially, with 95% from existing customers and only a 4% cancellation rate, while supply chain constraints are expected to persist despite mitigation efforts.
  • The company repurchased 14.4 million shares in Q2 for $800 million (totaling $1.5 billion YTD) and increased its share buyback authorization by $1 billion.
AI Generated. May Contain Errors.
Earnings Conference Call
Fortinet Q2 2022
00:00 / 00:00

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 call is being recorded. I would now like to hand the conference over to your speaker today, Peter Selinski.

Operator

Please go

Speaker 1

ahead. Thank you. Good afternoon, everyone. This is Peter Salkowski, Vice President of Investor Relations at Fortinet. I'm pleased to welcome everyone to our call to discuss Fortinet's Thank you for joining us today.

Speaker 1

Speakers on today's call are Ken Xie, Fortinet's Founder Chairman and CEO and Keith Jensen, our Chief Financial Officer. This is a live call that will be available for replay via webcast on our Investor Relations website. Ken will begin our call today providing a high level on our business, Keith will then review our financial operating results for the Q2 before providing guidance for the Q3, updating the full year. We'll then open the call for questions. During the Q and A, we ask that you please limit yourself to one question and one follow-up question to allow for 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 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 the earnings press release And in the presentation that accompany today's remarks, both of which are posted on the Investor Relations website, Ken and Keith's prepared remarks today for the earnings call will be posted on The earnings section of our Investor Relations website immediately following today's call. Lastly, all references are on a year over year basis unless noted otherwise.

Speaker 1

I'll now turn the call over to Ken.

Speaker 2

Thanks, Peter. Thank you to everyone for joining to this call to review our outstanding Q2 2022 result. Total billings increased 36%, the 6th consecutive quarter of at least 35% year over year billing growth. Revenue grew 29%, driven by 34% product revenue growth SD WAN and OT booking grew over 60% and 75%, which together accounted for 25% of total second quarter bookings. Our better than expected performance demonstrate the strong demand for our cybersecurity innovation.

Speaker 2

Fortinet is at the forefront of networking and security convergence, enabling our customer to reduce Complexity while securing and connecting hybrid and remote user to advanced security with superior performance. Today, we announced the FortiGate 4800F, our latest innovation in converged network security. The 4800F is the world's fastest compact firewall for hyperscale datacenter and 5 gs network. Powered by Fortinet MP7 SPU, the 4800F delivers security computing Of on average 5 to 10 time better performance than competitive solutions across the 6 most common and important functions, A leader in the government major quadrant for 1 edge infrastructure, Fortinet continued to take market share for Secure SD WAN. Our integrated secure SD WAN solution powered by Fortinet SPU SoC 4 deliver huge performance, Security and efficiency over traditional offerings.

Speaker 2

In addition to convergence, Consolidation of vendor and product functionality is another major trend, particularly in our security. In a recent CECL survey, Garner found the percentage of companies surveyed who want fewer security provider increased to 75% We're only 29% in 2020. With over 30 product lines built mostly by our in house Strong engineering and development innovation. Fortinet has benefited from this consolidation with our security fabric mesh offering. The Fortinet security match platform delivered unparalleled protection with a broad integrated and automated protection Across multiple edge from endpoint to data center and hybrid cloud environment, these two major trends, Convergence and consolidation position Fortinet well for long term growth.

Speaker 2

Before turning the call over to Keith, I would like to thank our employees, Customers, partners and suppliers worldwide for their continued support and hard work that are contributing to Fortinet's strong growth.

Speaker 3

Thank you, Ken, and good afternoon, everyone. Let's start with a more detailed quarterly discussion. 2nd quarter results were solid and broad based Across geographies, customer sizes, industries and use cases, driving market share gains and demonstrating the strong growth from our 3 key growth drivers. 1st, an elevated threat environment 2nd, the convergence of security and networking and third, the consolidation of security products across our platform offerings. Total revenue of $1,030,000,000 was up 29%, passing the 1,000,000,000 in quarterly revenue for the first time in our history.

Speaker 3

Total product revenue growth was up 34%. Core platform and platform extension product revenue growth was up 35% 33%, respectively. We continue to see robust product revenue growth from a wide range of security use cases, including secure SD WAN and Operational Technology or OT. Total service revenue growth increased sequentially to 25%, Resulting in service revenue of $629,000,000 Support and related service revenue was up 26% To $289,000,000 while security subscription service revenue was up 25% or 2 points sequentially to $340,000,000 Service billings defined as total billings minus product revenue We're up 36%. The year over year growth rate for short term deferred revenue has increased for 6 quarters in a row From just under 21% in Q4 of 2020 to just over 31% in Q2 of 2022, the highest short term deferred revenue growth rate in over 6 years.

Speaker 3

The accelerating growth rate for service billings And short term deferred revenue reflect the earlier pricing actions that quickly appeared in product revenue and are now beginning to appear in service revenue. The pricing benefit more than offset various service revenue headwinds, including suspending services in Russia, An increase in the average number of days between when a customer purchases and subsequently activates a security service contract And the impact of contract manufacturers delaying deliveries to later in the quarter, which limits our service revenue on new sales Recognized in the quarter. With the growth in pricing benefits more than offsetting these headwinds, We expect service revenue growth will continue to accelerate through 2022 and into next year. As summarized on Slide 6, total revenue in the Americas increased 23%. EMEA revenue increased 28% And APAC posted revenue growth of 42%.

Speaker 3

Despite macro conditions that may be more readily impacting other industries, Our pipeline growth remains strong. In particular, EMEA's pipeline growth indicates continued strength in our European business. Moving to a summary of our success with the large enterprises. Large enterprises continue to favor Fortinet's leading cost or performance advantage And are increasingly more appreciative of our integrated platform. The platform strategy allows customers to converge networking functionality For security capabilities and consolidate multiple point products.

Speaker 3

Our success with a large enterprise customers includes Global 2,000 bookings growth of over 65% year over year and on a rolling 4 quarter basis. Large enterprise booking growth of over 55% year over year and on a rolling 4 quarter basis. And the number of deals over $1,000,000 increased over 50% to 122 deals And the total billings value of these transactions doubled. Secure SD WAN bookings grew over 60%, Reflecting the convergence of networking and security as well as a strong ROI for our customers. OT bookings were up over 75%, Reflecting the continued response to the elevated threat environment.

Speaker 3

Shifting to billings. Billings of $1,300,000,000 were up 36%, As Ken pointed out, representing the 5th consecutive quarter of billings growth in excess of 30%. I'll pause here to offer thoughts on product refresh cycles and their impact on our financial results. Specifically, We do not believe new product releases drive a near term spike in our top line growth. Rather, we believe the continual nature of our product releases drives long term growth.

Speaker 3

For example, each new ASIC is included in a series of products released over several years. Our most recent ASIC chip, the NP7 secondurity processing unit was introduced in Q1 of 2020, Including the 4800F announced today, we have released 9 high end core platform products with the NC7 Chip. And over the next several quarters, we will release several additional mid range and high end products with the MP7. Lastly, I would note that since the start of 2019, we have released over 23 new FortiGate models. While some of our competitors, Which have much shorter product SKU list may have shown clear signs of product refresh cycles.

Speaker 3

Our strong long term performance illustrates an extended series of overlapping product maturity curves. Core platform billings were up 32% and accounted for 69% of total billings. As shown on Slide 7, midrange FortiGates posted very strong buildings growth with the ship mixing 5 points in their favor, Driven by demand as well as supply availability. Platform extension billings were up 44% And accounted for 31% of total billings, a mix shift of over 1.5 points. Average contract term was up 1 month year over year to 29 months, driven by the strength from large enterprise customers and the 50% plus Increase in the number of deals greater than $1,000,000 Worldwide, government buildings grab the largest share of the mix at 15% And we're up 45%.

Speaker 3

The top 5 verticals accounted for 60% of total billings. Moving back to the income statement, Total gross margin of 76.5 percent exceeded the midpoint of the guidance range by approximately 125 basis points, Even as component, labor and freight costs increased and the year over year revenue mix shifted 2 points to product revenue from higher margin service revenue. Product gross margin of 61.9% was up 20 basis points year over year And 450 basis points sequentially as pricing actions, product mix and lower discounting offset higher component and other costs. Service gross margin of 85.9 percent was down 100 basis points due to increased costs associated with the expansion of our data center footprint As well as labor costs and other costs, partially offset by benefits from FX and some of the earlier pricing actions. Operating margin of 24.8 percent exceeded the midpoint of the guidance range by approximately 200 basis points.

Speaker 3

The year over year comparison saw the FX benefit offset by lower gross margins, increased travel and marketing costs and other costs. Headcount increased 27 percent to $11,508 Looking to the statement of cash flow summarized on slides 89. Free cash flow was $284,000,000 and was impacted by increases in DSO and cash taxes. DSO increased 14 days year over year and 5 days sequentially to 80 days due to the change in billing linearity Driven by the timing of inventory deliveries from contract manufacturers. And new R and D capitalization rules increased second cash taxes by $85,000,000 to $110,000,000 Second half cash taxes of approximately $135,000,000 Are expected to be more evenly spread across the 3rd and 4th quarters.

Speaker 3

For the first half of the year, our adjusted free cash flow margin, Which excludes real estate spending was 34%. Capital expenditures for the quarter were $39,000,000 including $21,000,000 for real estate investments. We repurchased approximately 14,400,000 shares of our common stock for a cost of $800,000,000 Bringing the total year to date shares repurchased to $25,800,000 for a total cost of 1,500,000,000 The Board increased the share repurchase authorization by $1,000,000,000 The remaining repurchase authorization is now 1,030,000,000 Inventory turns of 3.1 times were up a half turn year over year and down a half turn sequentially. Moving to bookings and backlog. As a reminder, backlog is excluded from current quarter billings and revenue.

Speaker 3

Nonetheless, is it expected to provide increased visibility in the top line tailwind in future quarters? Bookings were up 42 percent to $1,400,000,000 Total backlog of $350,000,000 is up $72,000,000 sequentially It reflects very strong demand. Of the total backlog, networking equipment accounted for about 50%, while FortiGate accounted for about 40%. We believe our backlog is very strong and sticky. Existing customers account for over 95% of total backlog And no single end customer accounts are more than low single digits as a percentage of backlog.

Speaker 3

There are 4 deals in backlog, All from previously existing customers with the remaining balance of over $2,000,000 but together account for only 6% of total backlog. Just 4% of ending Q1 backlog was canceled in Q2 and about half the deals in the backlog have been partially fulfilled, Suggesting that double ordering is not a significant contributor to backlog. Consistent with the Q1, We shipped approximately 60% of the prior quarter's backlog in the current quarter as our operation and R and D teams did an excellent job navigating The tough supply chain environment. Nonetheless, we still expect supply chain constraints to be challenging throughout the remainder of the year. We're continuing to address the supply chain challenges in a number of ways, including by increasing inventory purchase commitments, redesigning products, qualifying additional suppliers and certain pricing actions.

Speaker 3

We believe that even with these actions, demand will continue to outstrip supply. As a result, we expect backlog to continue to increase in 2022. And while the situation is very dynamic, We believe we will have access to sufficient inventory to meet our guidance. As we balance our pricing actions with the opportunity for continued market share gains, We have passed along most, but not all cost increases. As such, we expect ongoing gross margin volatility From these increases as well as shifts in our product mix related to inventory availability.

Speaker 3

Before reviewing our guidance, Let's offer a few Fortinet specific observations in areas you may have heard discussed elsewhere. In Q2, We noticed certain larger transactions with increased or elongated negotiating cycles. Also, linearity pushed to later in the quarter And later in the last month of the quarter, mainly due to supplies constraints and the deliveries. Lastly, close rates were strong and importantly, The aggregate value of deals that pushed were within our historical norms. Now I'd like to review our outlook for the Q3 as summarized on Slide 10, Which is subject to the disclaimers regarding forward looking information that Peter provided at the beginning of the call.

Speaker 3

For the Q3, We anticipate our solid third quarter pipeline growth across deal types, sizes and geographies to support the following: Bookings in the range of $1,455,000,000 to $1,485,000,000 which at midpoint represents bookings growth of 36%. Billings in the range of $1,385,000,000 to $1,415,000,000 which represents growth of 32%. Revenue in the range of $1,105,000,000 to $1,135,000,000 which represents growth of 29%. Non GAAP gross margin of 75 percent to 76 percent non GAAP operating margin of 25% to 26 percent Non GAAP earnings per share of $0.26 to $0.28 which assumes a share count of between $810,000,000 $820,000,000 We estimate 3rd quarter capital expenditures between $105,000,000 $115,000,000 We expect a non GAAP tax rate of 17%. For the full year, we anticipate backlog that could approach or possibly exceed $500,000,000 that will be offset by robust industry growth, Pipeline strength and market share gains fueling our growth and supporting the following: billings in the range of $5,560,000,000 to $5,640,000,000 which at the midpoint represents growth of 34%.

Speaker 3

Revenue in the range of $4,350,000,000 to $4,400,000,000 which represents growth of 31 percent. Total service revenue in the range of 2,620,000,000 To $2,670,000,000 which represents growth of 27% and applies full year product revenue growth of 38%. We expect non GAAP gross margin of 75% to 76%, non GAAP operating margin of 25% to 26%, Non GAAP earnings per share of $1.01 to $1.06 which assumes a share count of between $810,000,000 to 820,000,000 We estimate full year capital expenditures between $300,000,000 $330,000,000 We expect our non GAAP tax rate to be 17%. We We expect cash taxes for the year to be $265,000,000 As I mentioned earlier, cash taxes paid are higher in 2022 due to the new R and D capitalization rules in the U. S.

Speaker 3

Along with Ken, I'd like to thank our partners, customers, suppliers and all members of the Fortinet team for all their hard work, execution and success. 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

Operator

Thank you. At this time, we will conduct the question and answer session. And wait for your name to be announced. Please standby while we compile the Q and A roster. Our first question comes from the line of Brian Essex with GS.

Operator

Brian, your line is open.

Speaker 4

Great. Thank you. Good afternoon and thank you for taking the question. Congrats It came on a nice set of results for the quarter. I was wondering if maybe and Keith, I certainly appreciate the commentary and granularity With the full year revenue guide, can we maybe unpack some of the commentary on the services side and the lower, I guess services revenue guide for the year.

Speaker 4

Maybe help us understand what's going on there and maybe pair that with your comments Delays on activations and how much insight you might have there that gets folks comfortable that there isn't pull forward? Thank you.

Speaker 3

Yes. I don't think Brian, I don't think pull forward really applies to the service revenue line, but maybe you're asking a couple of questions at once. I think to answer your question about service revenue, I think the biggest change from where we started the year is really about Russia. If you think about Russia, we talked at the very beginning, it's about 1.5% of our total revenue And that applies to the service revenue line as well. Earlier in the year, we stopped recognizing revenue on existing contracts for services that provide in Russia In conjunction with our suspending of services.

Speaker 3

At that time, we did not anticipate it would be a full year event, but we are now. And if you kind of think through that 1.5 percent of service revenues Russia, so we really backed out now for the full year about $25,000,000 of revenue related to Russia. That's the largest Change there. I think the delay in registrations from when contracts are sold, when they're actually registered by customers, I think we pretty much got out of the quarter what we expected on that. That seems to be something in the current environment where the inventory constraints that we're going to continue to see.

Speaker 3

I think the linearity part of it is a little bit new in that, because the shipments occurred later in the quarter, There really wasn't the opportunity to get the service revenue from those Q2 shipments that we would normally get. And so I think those are really the Parts to put together there. On the other side, I would probably point to again the short term deferred revenue billings and the number that we're putting up and the growth that you're seeing That number as well as service billings itself. And I think the last comment on this and we haven't talked about it before is that the service contracts are really Use it or lose it contract, meaning it's not that they have the ability to cancel, they just have the ability to postpone the registration for period of time, whether depending on the geography, whether that's 90 days or 1 year or what have you. So eventually it comes to revenue, but the timing has been pushed out for that aspect.

Speaker 4

Got it. That's very helpful. Thank you.

Operator

Thank you, Brian. Our next question comes from Fatima Boolani with Citibank.

Speaker 5

Good afternoon. Thank you for taking my questions. Hey, Keith, this

Operator

one's for you. Just with respect to some

Speaker 5

of the backlog Excuse me, detail and commentary that you shared. I want to hone in on the cancellation rates that you quantified for us. I believe you It was about 4%. Can you give us a sense of what are some of the reasons behind the cancellation? And what gives you confidence that that 4% Is it going to stretch or escalate into maybe mid to high single digits?

Speaker 5

Thank you.

Speaker 3

Yes. I think I would point to some of the factors that we've talked about before. I think that last quarter we talked about the cancellation rate being 5%. I think we're seeing it now at 4%. I think it's unlikely that existing customers, particularly those that have received partial shipments are going to cancel.

Speaker 3

Also, I don't want to think that it's naive that as Backlog gets older and it's also why we provide that 60% of shipments from prior backlog number for The Street to try and understand it. But if that number starts To tick up, obviously there's more risk in it. I think it's important to understand the guidance that we provide really isn't reflecting in any sort of Shift in the backlog that we're going to ship a lot of things from backlog. So I think we're fairly prudent in that regard and I think we're also comfortable with that described as the stickiness of the backlog number.

Speaker 6

Operator, next question.

Operator

Okay. All right. Thank you for that question Fatima. Our next question comes from Adam Borg with Stifel.

Speaker 7

Hey guys, and thanks so much for taking the questions. Maybe just on the macro, you talked a little bit about the demand environment And I highlighted some delayed deals and elongated linearity. Can you maybe go a little bit deeper here and talk about what these customer conversations look like? Are these ties to any Particular verticals or geographies, you talked a little bit about large enterprise or larger deals, I'd love to hear about the midsize and smaller deals too. Thanks.

Speaker 2

This is Ken. So we do see a lot of customers, especially enterprise, They started to design some new infrastructure to support in the Wolfram Anywhere and also expand security beyond the traditional network Security and into whether like internal segmentation to prevent all this ransomware attack or go to work from home And at the same time, have multiple security product need to be automated integrated together, so we call it consolidation, both on the product side and on the vendor side. I feel this kind of trend will be lost for the next few years, will be pretty long term change. And at the same time, Keith also mentioned, Alavi security threat environment also another drive. So that's where we see the Trend was keeping going for the next few years.

Speaker 2

Like if you look at the building number compared to 2 years ago, I mentioned in my script is we have a over 35% of building increase in the last 5 quarter Compared to 2 years ago, Q1 2020 is only about 14%. So we do see the change in acceleration and also the convergence consolidation Going on in the whole space right now will be pretty much right amount of growth.

Operator

Our next question comes from Saket Kalia with Barclays.

Speaker 6

Okay, great. Hey, guys.

Speaker 8

Thanks for taking my question here. Keith, maybe for you, I'd like to talk a little bit about bookings. Can you just talk about how bookings did versus Your expectation this quarter, I think the guide coming into Q2 was for about 40% growth. We came in at 42%, clearly better, But a bigger delta on the billings versus the guide. And so can you just talk about how to read into that if there's anything to consider there with Those 2 kind of in relation to each other?

Speaker 8

Yes.

Speaker 3

I don't I think obviously 42% bookings, I think we've been over 40% now for 3 quarters, maybe 4 The bookings line, we feel really, really good about it. I think the one thing that we're looking at internally is just that the Interplay between bookings, backlog and billings and trying to really get a sense of what the direction of the business. The example I kind of gave us, we had a very good quarter on the mid range of the product. But some of that was due to availability. Demand was very strong, but it was also because we had the mid range product available.

Speaker 3

We didn't have as much product available in the low end. Now, as we shifted this Q3, I think we're probably See the low end availability improved pretty dramatically. And so when you're looking at billings information that we have historically disclosed and trying to gauge the direction of the business, it gets a little bit distorted now just in terms of what's available. And I think of the total, when you look at bookings and backlog, there's some of that as well in terms of The characterization of what the booking is versus the characterization of what's available to ship and what comes in the billing slide.

Speaker 8

Got it. Very helpful. Thanks.

Speaker 2

Yes. Also compared to 1 year ago, maybe a tough comparison Because we started to see the acceleration about 5 quarters ago.

Operator

Wonderful. Our next question comes from Adam Tindle with Raymond James.

Speaker 9

Okay. Thanks. Good afternoon. Keith, You talked in the prepared remarks about still expecting supply challenges for the rest of the year and to offset your thinking increased purchase commitments, qualifying additional suppliers And pricing actions, I wanted to zoom in on that last point on pricing actions to see if you would maybe put a finer point on timing and magnitude for expected pricing actions. And secondly, you sounded positive on elasticity and confident on elasticity moving forward.

Speaker 9

But just curious what underpins that confidence, especially in International markets with dollar strengthening and local currencies and fixed budgets, etcetera. Thank you.

Speaker 3

Yes. Great question. And I'll take the last one first because I think it's probably Very important. I probably forgot the first one already. So one of the things that we do is we track very religiously in our CRM tool when a customer if we lose a deal, we want to know why, Right.

Speaker 3

Is it because we could not overcome the incumbency? Is it because the channel partner may have had a bias, if you will, from one of our competitors, A feature issue, a functionality issue or something like that, but also very specifically, do we lose on price? And we've been tracking that now for over a year. And that percentage, which is low, lower than the other ones that I just gave in to you, has been extremely consistent. And so with that very consistent loss percentage, if you will, I translate that into price elasticity, which tells me that the question is always how far can you push the envelope.

Speaker 3

We know we come into the conversation with a significant price performance advantage. The Street sometimes or channel service may say 30% or 40%. We've known that from the beginning of this phase of the economic cycle. And the question has become, how far can we push that? But again, keep in mind, our goal is really to try over a longer period of time, Just match the cost increases and maintain a consistent margin.

Speaker 3

It's not that we're really trying to take down more margin. Now you will get volatility quarter to quarter Because of the mix and things like that. So long winded way to say, I think I really hang my head on what I'm seeing and we're tracking on the CRM data about reasons that we lose deals And reasons that we win deals.

Speaker 2

Yes. And also a few other comments about pricing. Our policy tend to be Adjust by the price by small step, but also kind of more often, like We do have a new price book basically released every quarter. Also, the other things really like the product we released Today, on average, for the same function, for the same price range, our product has a performance 5 to 10 times better than competitors. Like Keith mentioned on the CIM on the track, we don't see any deal loss kind of changing or even We feel deal loss actually improved because we still have a huge price advantage compared to competitors.

Speaker 2

The other thing also maybe mentioned to the service, I think one thing we may try to improve a little bit going forward is really Even in the last few quarters, we increased the price more on the new product release, but we have not changed the price for the expired product. Basically, the product still down every to the service like 5, 6 units, right? So that's one thing we made because the labor cost on the service on So we may have to increase the price of even outdated product, no longer shipping Because all the service, all the renewal are still tied to the old product, which is no longer shipping, but is the Customers still buying the renew, buying the service based on the old product. So that's probably we can also help in Improving the service and also will help in the margin and compensate our additional costs, especially on the labor.

Speaker 7

Very helpful. Thank you.

Operator

Our next question comes from Michael Turits with KeyBanc.

Speaker 10

Hey, guys. So Keith, two questions. First, Maybe it seems obvious in some ways, but do you feel like and this is the first time that you've talked about this linearity issue as well as the extension of the negotiation cycles. So do you simply tie it to macro being worse right now? Or do you have any other insights to it?

Speaker 10

And then I just wanted to make sure that in your mind, second question, you really think that it's really primarily Services as a result of those things, it's just shortfall on the year and you're happy with product.

Speaker 3

Yes. So I think the well, setting aside the fact that we broke the rule and you asked 2 questions and Peter said only one and a follow-up. I think what we're seeing on linearity, unlike a normal world where you can kind of look at linearity and DSO and can get a sense of whether or not a company is Pushing to close deals at the end of the quarter and maybe it's a more challenging quarter, because of the timing of when the finish when the inventory is delivered From the contract manufacturers, we saw we see a shift in that linearity of when we receive inventory from our contract manufacturers. That shift then translates into when we can turn around QA and etcetera and ship it out to our customers and sell it. So there's a different aspect of linearity that's come into play here now.

Speaker 3

So service contracts that maybe would have been sold in the 1st month of the quarter Actually got sold in the 3rd month of the quarter, so we lose service revenue from that. And you see that appearing in the DSO And you see it appearing in the free cash flow. On the negotiating side of it, I think what we saw and I don't know if this is common to Evers, but others. What we saw was probably the 1st 2 weeks of June And maybe there was more conversation around recession and concerns there, if you will. A bit of a pause in terms of deal closure rates for those 1st 10 days of June And then a reacceleration as we got through the end of June.

Speaker 3

We did notice or I did notice during that timeframe, Maybe additional parties were being introduced to either as an approver or negotiator, if you will, on some of the larger deals Just to make sure on the customer side that they were making the right decision. And I think that's why I went on to say in the prepared remarks, not only did we notice this But the close rates, which were important, actually were up just a tad in the quarter. So I think there was just for whatever reason, there was a slight pause there for a couple of weeks in June And everybody came back and got the deals done by on the customer side and our side at that last week in June.

Speaker 2

The other reason for a little bit longer closing The bigger deal grow faster. So like I mentioned, the deal over $1,000,000 Grow over 50% year over year. So that's the bigger deal also tend to be take a little bit longer time to close. And also we see More like a deal involving multiple products, not just the 40 ks, but also we call the non 40 ks, not called platform Extension, which also take a little bit long time to test, evaluate to close. On the supply chain since really compared to before the pandemic, we probably shipped majority, even most of the product by sea.

Speaker 2

Now we're pretty much shipping every product by air. That's where the timing of a Supply shipping the product to us is pretty critical for the linearity. And so last quarter, we do A lot of product being shipping at end of the quarter for supply to us. That's drive the linearity. Even if we have the ball game, but we have to wait Like a few weeks or even a couple of months before the product was shipping to the customer more towards the quarter end because the supply is shipping to us pretty much in the end of the quarter.

Speaker 2

So we do see long term, this will be changing, improving. We'll keep increasing some of the product inventory and improving the product turn and also balance among Not just shipping everything by ear, but some by ear, some by ocean.

Speaker 10

Thanks, guys.

Speaker 1

Thank you, Michael. Next question?

Operator

Our next question is from Keith Bachman with BMO.

Speaker 8

Hi, thank you. Good segue from Michael's question. Keith, I want to try to understand, you talked about a few different things Impacting the year guide and to put context around it, your revenue guide for 2022 It isn't changing, which I think is viewed as a disappointment to investors. Now underneath that services revenues is getting compressed a little bit. And so as you think about why the revenue estimates are going higher for the year, is there a change in A, the demand level, Whether it's the elongation, because you said in fact there was 2 weeks sort of week at the end of June, but it sounds like during The last through the 3rd August, things have normalized.

Speaker 8

Or is it B and or is it B supply chain issues that are causing You cannot raise your revenue guidance season, you're raising billings modestly. I'm just trying to understand what are the forces That are impacting the lack of raise, if you will. Is it the demand side and or is it the supply side?

Speaker 3

Yes. I don't really think it's necessarily either demand or supply. I would start the conversation off by saying I think the pipeline growth is extremely strong. We feel very, very good about that. Yes, I do think there's a fair amount of uncertainty as we look out beyond the Q3 to the Q4 in terms of directions the economies may go, what inflation may do And a little bit of supply chain.

Speaker 3

I don't think we did, as you point out, cover the shortfall, if you will, in the service revenue, Economies may go, what inflation may do and a little bit of supply chain. I don't think we did, as you point out, Cover the shortfall, if you will, in the service revenue in the product revenue. So I think that's a fairly good size of us being bullish And feeling very, very good about our competitive advantage. And I think that the other aspect we have talked about is just the large Deals and how we're seeing the success in the enterprise and getting a little more dependent on large deals than we have in prior years and some of the close rates around those. I think that while we're bullish, we think we have competitive advantages.

Speaker 3

I don't know as we get through the Q4, if this is really a good time To think about that in a very, very aggressive fashion.

Speaker 8

Okay. So if I just clarify, so it sounds like you want to be a little bit conservative or you don't want to get ahead of yourself on particularly the Q4 guide. So leave numbers where they are on revenues in particular?

Speaker 3

Yes. I think that's a fair description.

Speaker 8

Okay. I'll cede the floor. Or else Pete will yell at me.

Speaker 4

Thank

Speaker 1

you.

Operator

Our next question comes from shawlaiyal with Cowen.

Speaker 4

Thank you. So maybe Good afternoon, guys. I'm segueing from the prior question from revenue maybe to OpEx. So Your hiring plans appear to remain largely on track. What's the current thinking on second half?

Speaker 4

Is it becoming a little easier in recent months given some layoffs with some private competitors?

Speaker 2

Yes. We want to maintain healthy margin and then also keeping growing and gaining market share. I agree to hiring relatively a little bit easier compared to like a A few quarters ago, especially in the cybersecurity space. So for us, we feel we have a good pace on hiring, especially there. We still We're keeping gaining market share.

Speaker 2

And the margin and it's a healthy margin basically both On the gross margin, also on the operating margin side. So we feel maybe have pretty solid plan and balance among the growth and margin.

Speaker 3

Yes. I think Ken is spot on with that. I would probably offer a couple of things to support it. One is, you continue to hear us talk about our inventory commitments looking out now 6 quarters or more. I think either read through that is that we still felt fairly bullish about it.

Speaker 3

And the other aspect of it and We talked about 25% operating margins in different ways over the years as being an average or target what have you. And obviously, In this environment to with a high inflation to come in successfully and still be providing guidance for the full year of 25% to 26% While growing the top line aggressively, while taking market share, I think we feel very good about how the sales team, the engineering team, the operation teams, support teams, etcetera, all working together

Speaker 1

Thank you, Cheryl. Next question.

Operator

The next question comes from Hamzah Fodderwala with Morgan Stanley.

Speaker 11

Yes, good afternoon. Thank you for taking my question. Maybe a question for both Ken and Keith. Ken, Just given the general pressure on budgets in the macro environment, are you seeing a little bit more impetus to from customers to want to consolidate To a converged security networking platform like a Fortinet. And then, for Keith, if you're seeing any This, let's say, elongating negotiating cycles and whatnot, is it more weighted towards the core platform FortiGate side or the platform extension side

Speaker 2

It's a very good question. Definitely, we see the convergence among the network and Also the pandemic, our salary is going to change, especially Inside the company Compass Network and also work from remote anywhere. So that's where we see the pretty strong growth. And also A lot of connected device, like in the OT space, also we see very strong growth. Like we mentioned, SD WAN grew 60% And the OT grow 75%, and we're still keeping growing and gaining market share there.

Speaker 2

And at the same time, I have to secure the whole infrastructure, not only expanding on the network security to the networking side, but also like beyond the network With endpoint, with the cloud, with all the other like application level from email, by about this All working together, so we do see all these we keep in saying the convergence and the consolidation will benefit Fortinet, multiple year going forward, a small long term growth driver for us. And we prepared this in the last like 22 years since we started the company With investment like from ASIC Technologies with R and D with the most product internally And developed to integrate Automate together. And so we do see that time is starting to come in. And while this investment Starting to see some good return. And also, we feel we have a very healthy business model.

Speaker 2

Since IPO, now it's about 13 years now. I want to maintain a balance of growth and also a healthy margin, and that's what makes the company to last longer. And at the same time, We're also kind of keeping investing in the long term to follow the change and also Keep up the innovation and quickly customer benefit from our innovation and also long term investment.

Speaker 3

Yes. And Hamzah, I think your speculation about where the larger or the timing comes in is accurate and that It's going to be in that 1 third of our business that is large enterprise. 1, the dollars are larger obviously and so they're going to Customers spend a little more time with the ROI, but I think more importantly, into your kind of second point you've injected on, by adding in more of the platform products into a deal, You're perhaps a little more likely to run into additional competitors or into people internally that are champions of those competitors. And so there's a little more That it takes to get across the finish line because they are more complex in that way. I'll fill the void here.

Speaker 3

But I think As a reminder, we did 122 deals over $1,000,000 in the quarter, which that's a pretty fantastic number for us. Next question.

Operator

Our next question is from Gray Powell with BTIG.

Speaker 6

Okay, great. Thanks for taking the question. So Keith, I know you hit on this Once or twice already, but I just want to make sure I understand a dynamic on the services billings. So if I back out Product revenue from short term billings, it looks like the annual recurring component of billings Actually accelerated pretty nicely. I'm calculating like 29% in Q1, improving to 40% in Q2.

Speaker 6

I don't need you to blast the numbers, but directionally does that seem right to you? And then if so, how much of that was driven by Pricing dynamics that you talked about versus just the natural cadence of the business.

Speaker 3

I do think your math is directionally correct, but I don't want

Speaker 11

to spend a lot more time to get you

Speaker 3

to say even more about how accurate it actually or may or may not be because I'm looking at a different way. And I would say, again, if you think about the timing of where when a price increase is effective, right, it's got to go through the process of Being pre announced to the channel partners, they get, I think, 60 days of advance notice, and then when it actually starts to have an impact on it. But keeping that in mind, you are you do see the impact on pricing actions fairly quickly on product revenue and on billings, whether it's a product Or whether it is a service item, right? You will see it there. But on service revenue, you won't see that benefit for an extended period of time.

Speaker 3

And I think one thing that may help people is if you think back of our shift from 8x5 support to 20 fourseven support, we talked about that for several years Because when we turned off the 8x5 support, with that came a price lift. And the question that we were addressing, it seemed for 8, 12 quarters probably in a row, How was that mix shifting and how was that coming into it? And we were providing information back then about all the billings so to speak are under 20 4.57, But you're not seeing the revenue mix that way because it's got to that mix has to evolve over time as you go through the install base. Price increases for service revenue, this is just another flavor of the same thing that way. You're going to see the benefit over a much longer period of time on the service revenue line.

Speaker 3

You will see the benefit in billings much sooner and that's why we gave that information earlier and you kind of look at it. That's a very good leading indicator of where service revenue growth is going to go in

Speaker 6

Okay. That's really helpful. And then just a real quick follow-up. You mentioned $25,000,000 headwind On service revenue from Russia, which was a new headwind, does that apply to billings as well or was that purely a revenue dynamic?

Speaker 3

That was a revenue dynamic and I would probably say 40% of that probably there, 30% to 50% of that would have been a billings dynamic In terms of where we were from the beginning of the year, where we'll end up now.

Speaker 6

Got it. Okay. Thank you very much.

Speaker 1

Hope, next question.

Operator

Our next question is from John Weidmoyer with William Blair.

Speaker 6

Hi, this is John Weidmoyer for Jonathan Ho. Thanks for taking my question. On your platform extension, cloud security capabilities, I'm curious of the type of customer profile that's interested there. I suspect there's probably an existing Fortinet customer that's transitioning to the cloud. And I'm curious if there also may be a fabric mesh, and so there might be an all in customer An all in Fortinet type customer.

Speaker 6

Can you talk about the characteristics of

Speaker 1

the people that are going that route?

Speaker 2

We do see the cloud security growing well, Pretty much on a similar pace as our other like networking appliance growth. And also we do see a lot of cloud security come from the service provider, special carrier So that's what we're keeping saying. For better security, they need to secure the whole infrastructure, not just the cloud, but also appliance and some other part of infrastructure. So We do see more and more customers want to consider overall together. So basically, cost security also drive a lot of other Part of cybersecurity, under part of infrastructure for cybersecurity.

Speaker 2

And also we do believe long term, the service provider, Both in the telecom space, also in the security system integrator and also like even the cloud provider We'll play a very, very important role on this security, especially in the service part, and that's where we also want to keep supporting them. So that's where we see the it's kind of a still more hybrid environment going forward. And especially with the more and more device Connected with a lot of other we see kind of the whole infrastructure security kind of more and more important to connect. I mean, consider all

Operator

Our next question is from Greg Moskowitz with Mizuho.

Speaker 7

Okay. Thank you for taking the question. Good afternoon, guys. I'd like to ask about your backlog, which has Significantly and consistently increased over each of the last three quarters. It's dramatically above year ago levels.

Speaker 7

So Keith, You made it clear that the backlog should further rise by year end, which is great. But at the same time, it's not going to grow forever and it's It's common to see dips in the company's backlog due to seasonality, significant order shipments, cancellations, etcetera. And so it would just be helpful to get your sense of Perhaps when we begin to see ebbs and flows in the backlog metric, if you could offer anything there that would be helpful. Thanks.

Speaker 3

I don't expect when the supply chain is going to get better, Ken. So I'm going to let you handle that one.

Speaker 2

If you compare End of Q1, we increased backlog 120 some 1000000. And then End of Q2, we increased about $72,000,000 It's a little bit better, increased less than end of Q1 and also less than end of Q4, so there's some kind of improvement on increased backlog. But also, we put a lot of effort to sourcing different So different vendor design products. You see the product line, we got quite broad right now and also can Helping leverage some kind of I mean, some alternative or kind of a more broad supply chain for us. So that's why I do believe because the demand is still very, very strong.

Speaker 2

And so we do see things probably keeping Got a little bit better and better. But like I said, we probably not expect the backlog will reduce In Q3, Q4, but the increase probably will be less each quarter, let me put it this way. And then maybe next year, we'll see starting to see So but overall, with our engineering effort, with the kind of The investment we made in the operation in the manufacturer, we do see synthetic data improved a little bit better now.

Speaker 7

Yes. Makes sense.

Speaker 3

I think it's a logical place to have questions and I think Kent's comments are great. I would just add to that, keep in mind the This is why we provided some of the metrics there. We're not these are not airplane orders, right? These are relatively small dollar items, but compared to what you may see in other industries. That's why we gave some of the metrics on the size of it, if you will, and the fact also that their existing customers and many of those have been partially fulfilled.

Speaker 3

I mean, we all have the same concern and the question is, how do you get comfortable with that backlog is sticky and it's going to be here when the product when the supply chain loosens up. And that's why we're giving us metrics For people to get some sort of context, but I would keep in mind, these are comparatively the other industries, construction industry, airline, what have you, these are very small dollar amounts.

Speaker 2

Yes. Also the age of our backlog probably much better than our competitors. Like Kipi mentioned, in the last 2, 3 quarters, every quarter, Even we increased the backlog and we fulfill probably like 60% even over 60% of previous quarter backlog. So that's making our agent back up also pretty short, a few months compared to most other competitors. Sometime, it may take 1 to 2 years to deliver.

Speaker 2

So that gave us a pretty good position and also the customer trust continue working with us during this supply At the same time, we offer quite a broad product. There's always some kind of alternative product because it suggests our customer to use if 1 or 2 products have shortage.

Speaker 7

Very helpful color. Thank you both.

Speaker 2

Yes. I think we deliver over 90% of NA bookings every quarter, I believe.

Speaker 1

Yes, the booking is between 90%

Speaker 2

to 95% of the booking we do deliver the product.

Speaker 1

Thanks, Craig. All right.

Operator

Our next question comes from Andrew Nowinski with Wells Fargo.

Speaker 6

Okay. Thank you

Speaker 8

for squeezing me in and congrats on another great quarter. I had a question on free cash flow. So I think you So you expect the low end supply of appliances to dramatically improve in Q3. So is there a margin or free cash flow impact that mix shift In Q3 and then related to that, given the shortfall on services that we saw in Q2 and the negative impact it had on your free cash flow, Should we expect free cash flow to rebound in Q3 and Q4? Or are you assuming the linearity remains unchanged in those quarters?

Speaker 8

Thanks.

Speaker 3

Yes. I'm assuming the linearity is I don't really have any reason to think that's going to be any different. I'm looking for a reason to find, but I certainly have not found one yet. So Yes. When we look at what our expectations are internally and while we don't guide to free cash flow, we try and give information that's helpful to others.

Speaker 3

I would assume that I have no reason to assume anything other than we'll still See more of the same if you will. And I think the first part of your question was you asked about low end and about margin and Maybe I can offer a little bit of commentary there. When you look at our FortiGate firewall product families, the entry level or low end as you call it, mid range and high end, In general, the margins increase the gross margin increases as you move up from the entry level to the higher end of it. So from that aspect of it and that's why the comments in the script that there can be gross margin volatility both from the pricing actions that we've taken And the discounting as well, but also the mix of our product. So in a quarter that we see a higher mix of higher end Firewall shipments margins will be higher by definition, but there's many puts and takes in there that we when we go through the gross margin guidance that we give, Hopefully, we're considering all the different puts and takes that are in there, not just the mix of the inventory and the pricing actions.

Speaker 4

Thank you.

Speaker 1

Operator, last question please.

Operator

Our last question comes from Roger Boyd with UBS.

Speaker 8

Hey, thank you very much for taking the questions.

Speaker 6

Keith, I was curious, just to go back

Speaker 3

to the backlog for a second.

Speaker 8

You had mentioned the split being about fifty-fifty between FortiGate and networking portfolio. Just wondering if you could talk about how you expect that mix And I guess the follow-up to that is what you're seeing around the supply constraints between those 2 product portfolios? Thanks.

Speaker 3

Yes, I might double check the numbers. I think it was 50%, fifty-forty between FortiGations and Networking Equipment. I have it backwards. Yes. Networking equipment is 50% and firewalls are 40% and then cash and dollars for the remainder of it.

Speaker 3

I think Everything that we seem to read in here, Ken probably knows more. The pressure certainly seems to be, for lack of a better term, more intense on switches and access points Than they do on firewalls. For a lot of reasons, I think we're more successful with firewalls.

Speaker 2

Yes, I agree. Probably on the Direction wise, we do see the 40 ks inventory will keep improving. So probably the percentage maybe a little bit more the backlog Probably a bit more towards the switching and AP side, which is probably the whole industry is suffering Some of the supply issue, the Fortinet, because we are more able to rather redesign and also use our own ASIC, which is also helping Kind of reduce the backlog and supply on time for the customer. But Yes. From the beginning of this backlog issue almost 1 year ago, Definitely, we see the shift in a little bit more towards the networking side, so they have a little bit longer backlog.

Speaker 3

Very clear.

Speaker 8

Thanks for the color.

Speaker 1

Thank you. Thank you.

Operator

I would now like to turn it back to Peter Salkowski. Thank

Speaker 1

I'd like to thank everyone for joining the call today. Fortinet will be attending investor conferences hosted by KeyBanc, Citibank, Evercore, Stifel and Goldman Sachs During the Q3, fireside chats will be available through our IR website. Please let me know if you have any follow-up questions. Feel free to contact me and have

Operator

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

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