Keith Jensen
Chief Financial Officer at Fortinet
Thank you, Ken, and good afternoon, everyone.
As Ken mentioned, we are confident in our integrated FortiOS driven platform strategy, which is summarized on slides 6 through 10 of the earnings slide deck. As we look forward, we believe shifting our R&D and go-to-market investments to the faster growing SASE and SecOps markets is consistent with near-term market opportunities.
As shown on Slide 10, SASE and SecOps account for 20% and 10%, respectively, of our business today. And, as shown on Slide 7, these markets are expected to grow in the mid-to-high teens annually.
Secure Networking, which currently accounts for 70% of our business, is expected to experience slower growth, following two years of very robust growth. As a result, for the near term, we expect to deliver healthy profitability along with more modest growth.
With execution and continued investment in the SASE and SecOps markets, we believe we can return to delivering mid-to-high teens top level growth -- top line growth and while continuing to deliver operating margins of 25% or greater, in other words, a return to the balanced growth and profitability which has led us to achieve the Rule of 40 status in 12 of 15 years as shown on Slide 19.
In a moment, I'll expand on the strategic shift by sharing a few of the tactical steps and investments. But first, I'd like to review some highlights from the quarter. We continued to add new logos at an impressive rate and saw top line performance in Small Enterprise and software, was strong, while operating margin and free cash flow were above expectations. We added over 6,400 new logos, supported by Small Enterprise customers which grew bookings by 19%.
Our efforts to manage personnel and other costs drove our operating margin to 27.8%, 230 basis points above the high-end of the guidance range. Free cash flow was strong at $481 million, representing a margin of 36%.
Looking at billings. Starting from the third quarter of 2020, we saw a three-year compound annual billings growth rate, or CAGR, of 26%, illustrating our ability to drive strong and sustained growth over an extended period. In Q3, however, billings of $1.49 billion represented growth of 6% as we experienced one-month shorter contract duration, and importantly lackluster appliance demand resulting from elevated product growth in earlier periods.
In terms of industry verticals, education and government billings were strong, while service provider and retail billings were weak. Small Enterprise billings growth was strong, while growth rates with larger enterprises disappointed. Billings growth varied by geo with International Emerging showing strong growth, while our much larger geos of Europe and the US were weaker.
Turning to revenue and margins. Total revenue of 16% -- sorry, total revenue grew 16% to $1.33 billion, which compares to our three-year CAGR of 27%. The three-year CAGR was largely consistent with our 14-year CAGR illustrated on Slide 18. Product revenue of $466 million, representing a three-year CAGR of 28%, was down 1%, reflecting product lead times and backlog aligning with historical levels, and the lighter levels of Network Security demand Ken referred to. Service revenues of $869 million grew 28%, representing a three-year CAGR of 27%. Service revenue accounted for 65% of total revenues, driven by 34% growth in higher margin security subscriptions, which represents 57% of total service revenue.
We mention the three-year CAGRs to illustrate how consistent they are with these same CAGRs starting from our 2009 IPO which are illustrated on Slide 18. Each of the three-year CAGRs, billings, product revenue, service revenue and total revenue, are within five points of the 14-year CAGRs for the same top line metrics, adding to our confidence in returning to higher growth levels.
Product gross margins were down 310 basis points as we saw margin pressure related to inventory levels. Service gross margin was up 60 basis points as service revenue growth outpaced higher levels of cloud and hosting costs. Total gross margin of 76.9% was up 70 basis points, driven by the increase in service gross margins and the six-point mix shift from product revenue to service revenue.
Operating margin of 27.8% exceeded the high-end of the guidance range and operating income of $371 million was $33 million higher than consensus and $20 million above the high-end of our guidance range, reflecting our efforts to control spending.
Looking to the statement of cash flow summarized on slides 15 through 17. Free cash flow increased 22% to $481 million, representing a free cash flow margin of 36%, or 9 points above consensus. Operating cash flow increased $68 million to 41% of revenue.
Capital expenditures were $70 million, including $50 million of real estate investments. Cash taxes paid in the quarter were $26 million.
As a reminder, free cash flow benefited from regulatory relief in the form of deferred estimated and other tax payments in the second and third quarters, totaling $192 million and $18 million, respectively. In the fourth quarter, we expect cash taxes to total $345 million, including the $210 million of deferred tax payments.
We repurchased 10.4 million shares of our common stock for an aggregate cost of $605 million in the third quarter. In October, we purchased an additional 7.7 million shares for $444 million, and our remaining share repurchase authorization stood at approximately $980 million at the end of October.
Now, I'd like to share a couple key SASE wins for us in the quarter. In a seven-figure upsell win, an existing financial services customer initiated their Single Vendor SASE solution for 50,000 users. Fortinet was able to displace another incumbent as the customer continued their consolidation journey with us, supplementing their earlier SecOps, Cloud, and Network Security purchases.
And in a six-figure deal, an existing SD-WAN customer continued their strategic transition to SaaS and cloud-based applications by adding our SASE solution for 2,000 users. We believe existing SD-WAN customers such as this one, offer a rich cross-sell opportunity for our SASE solution.
It's worth noting these deals closed before our recently announced partnership with Google Cloud, which significantly expands our PoP coverage by adding over 100 locations and prior to Gartner's release of the inaugural Single-Vendor SASE Magic Quadrant, where we were named a Challenger. By 2025, one-third of new SASE deployments are expected to be single vendor. We should also note Fortinet is recognized in nine Gartner Magic Quadrants, as shown on Slide 3.
Now I'd like to expand on Ken's strategic commentary with some of the tactical investments we are making to increasingly focus our efforts on SASE and SecOps.
In the areas of research and development and solution delivery, in addition to the new Google Cloud Partnership I just mentioned and our own data center investments, we are continuing to integrate Single Vendor SASE features into FortiOS and continuing to expand our SecOps capabilities with AI technology and additional functions and enhanced integration, and finalizing co-development agreements with existing large enterprise customers to accelerate continuous improvement of our integrated enterprise level SASE solution.
Our go-to-market strategy investments include: actively promoting our Challenger position in Gartner's Single Vendor SASE Magic Quadrant, focusing on third-party certification of our broad and integrated solutions, including SSE and SD-WAN and aggressively marketing Fortinet's competitive advantages and the key components of SASE, SecOps and network security as summarized on Slide 10; certifying 5,500 Fortinet sales professionals in SecOps solutions after already certifying these same sellers in SASE, which is the largest sales enablement motion in company history; investing in sales comp plans to include incentives to sell SASE and SecOps capabilities to existing and new customers; expanding partner rolls deeper into channel partners specializing in SASE and SecOps; and developing channel training that is focused on differentiating Fortinet's comprehensive and integrated SASE and SecOps capabilities.
We believe Fortinet remains well-positioned in the cybersecurity market and the market shift to platform strategies is in early stages. According to Gartner, 75% of companies are pursuing a vendor consolidation strategy, reflecting the evolving landscape of cybersecurity in a highly fragmented industry with thousands of vendors. As shown on Slide 9, Fortinet brings consolidation across SecOps, SASE, and Networking Security, the three key growth drivers in our strategy.
Organizations are recognizing that an integrated security solution with a single operating system is the best method to improve their security posture as this approach allows each security solution to share data and communicate with each other, reducing complexity and improving security effectiveness.
Attempting to piece together best-of-breed solutions from a multiple vendors can result in slower AI-driven technology adoption, significant security gaps, and a slower pace of identifying, reporting and resolving security incidents.
Moving to guidance. We continue to see increased deal scrutiny and longer sales cycles, which is constraining our near-term results. We expect these longer sales cycles to continue, along with the associated budgetary scrutiny, and our fourth quarter guidance takes this into consideration.
As a reminder, our fourth quarter and full year outlook, which are summarized on slides 20 and 21, is subject to the disclaimers regarding forward-looking information that Peter provided at the beginning of the call.
In the fourth quarter, we expect: billings in the range of $1.560 billion to $1.700 billion, which at the midpoint represents a decline of 5%; revenue in the range of $1.380 billion to $1.440 billion, which at the midpoint represents growth of 10%; non-GAAP gross margin of 75.5% to 76.5%; non-GAAP operating margin to 27.5% to 28.5%; non-GAAP earnings per share of $0.42 to $0.44, which assumes a share count between 780 and 790 million; capital expenditures of $40 to $60 million; a non-GAAP tax rate of 17%; I think, cash taxes, as I mentioned, of $345 million.
For the full year, we expect: billings in the range of $6.095 billion to $6.235 billion, which at the midpoint represents growth of 10%; revenue in the range of $5.270 billion to $5.330 billion, which at the midpoint represents growth of 20%; service revenue in the range of $3.355 billion to $3.375 billion, which at the midpoint represents growth of 28%, the service revenue guidance implies product revenue growth of 9%; non-GAAP gross margin of 76% to 77%; non-GAAP operating margin of 26.5% to 27.5%; non-GAAP earnings per share of $1.54 to $1.56, which assumes a share count of between 790 and 800 million; capital expenditures of $220 million to $240 million; non-GAAP tax rate of 17%; and cash taxes of $430 million.
As we look forward to 2024 and transition from a period of elevated product growth, we can offer a few thoughts looking forward. In the near term, we will continue to focus on improving profitability. We expect product gross margins to be pressured in 2024. Nonetheless, we expect healthy operating margins that are 25% or greater. We expect to gradually increase billings growth through the year and approach double-digit growth by the second half of 2024, reflecting the progressively easier comps due to the easing of the headwind from backlog drawdowns in the first half of 2023 and the benefit of our SASE and SecOps focus. We expect contract term to remain below our high-water marks in 2022. Consistent with prior years, we expect that the timing of service revenue growth trends will lag product growth trends.
Longer term, we remain confident in our solutions and our ability to adopt our strategy to shifts in the market, taking market share as we increase our investments in SASE and SecOps, ultimately returning to balanced growth and profitability.
I look forward to updating you on our progress in the coming quarters.
And with that, I'll now hand the call back over to Peter to begin the Q&A.
