Fortinet, Inc.

Ladies and gentlemen, thank you for standing by, and welcome to the Fortinet Second Quarter Earnings Announcement Conference Call. At this time, all participants' lines are in a listen-only mode. After the speaker's presentation, there will be a question-and-answer session, and to ask a question during this session, you need to press star 1 on your telephone. Please be advised that today's conference is being recorded, and if you require any further assistance, please press star 0. I would now like to hand the conference over to your speaker today, Peter Salkowski. Thank you, and please go ahead, sir.

Thank you, Chris. Good afternoon, everyone. This is Peter Salkowski, Vice President of Investor Relations at Fortinet, and I am pleased to welcome everyone to our call to discuss Fortinet's financial results for the second quarter of 2020. Speakers on today's call are Ken Zee, 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 by providing a high-level perspective on our business and and review our financial and operating results for the second quarter, provide some additional details regarding our second quarter performance, and some insights into how July performed before providing guidance for the third quarter of 2020. We'll then open the call for questions. During the Q&A session, we ask that you please keep your questions brief and limit yourself to one question and one follow-up question to allow others to participate. Before we begin, I'd like to remind everyone that on today's call, we will be making forward-looking statements, and these forward-looking statements 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-K 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 otherwise stated. Our GAAP results and GAAP to non-GAAP reconciliations is located in our earnings press release and in the presentation that accompanies today's remarks, both of which are posted on our investor relations website. Lastly, all references to growth are on a year-over-year basis unless otherwise noted. I will now turn the call over to Ken.

Thanks, Peter, and thank you to everyone for joining today's call to review our second quarter 2020 results. We are very pleased with our solid second quarter performance. Revenue increased 18% to $616 million, with product revenue up 12% and service revenue up 22%. Secure SD-WAN climbed to 12% of a total second quarter billions. The first time it's been over 10%. In today's environment, enterprises are focused on effectively and cost-efficiently deploying security across their physical, and digital network. To meet these challenges, Fortinet was founded on the vision of bringing security and networking together in what we refer to as security-driven networking. Gartner supports a similar concept, which they call secure access service edge, or SASE. Fortinet is an industry leader in building, integrating, and automating security product and service into Fortinet security fabric, including Fortis SASE. With the recent acquisition of OPEC network, Fortinet has enhanced its Fortisasi solution with expanded cloud delivery including firewall as a service and zero trust network access. Additionally, Fortisasi was built to be partner friendly, empowering MSPs and the big global customers to easily integrate or build Fortisasi platform into their own offerings. A critical component of Furnace Secure Fabric platform is SD-WAN. We recently announced the new FortiGate ATF, which expands our SD-WAN portfolio for branch offices and work from home. The FortiGate ATF, powered by the latest FortiSPU SoC 4, can deliver security compute reading as much as 25 times higher than industry average appliance using generic CPUs. According to Ghana worldwide SD-WAN equipment market data for the first quarter of 2020, Fortinet has the highest revenue growth and was the top three for market share. We attribute this growth to our ability to deliver secure high performance SD-WAN anywhere from home to the branch to the cloud. Security investment remain a priority for enterprise and service providers. demonstrated by the strong growth of our high-end FortiGate appliance during the last quarter. Today, we released the FortiGate 4400F, the only firewall in the industry capable of securing a hyperscale data center and 5G networks. Powered by the MP7 network processor, the 4400F delivers the highest performance with security computing reaching of up to 13 times higher than our competition. The release of several new appliance powered by our latest 4D ASIC SPU together with cloud and software based virtual machine to deploy security anywhere, we are able Fortinet to capitalize on this investment and put us in a strong position going forward. Before turning the call over to Keith for a closer look at our second quarter performance and our guidance, I would like to take a moment to welcome the over 400 people who joined Fortinet during the second quarter, as well as welcome the OPAC team who recently joined. And to thank our employees, customers, and partners worldwide for their continued support to manage our response to the ongoing COVID-19 pandemic.

Thank you, Ken. Let's start the second quarter review with revenue. Total revenue of $616 million was up 18%, driven by non-FortiGate product and service revenue growth of 25%. Non-FortiGate revenue growth benefited from very strong demand for virtual machines and our work-from-home solutions. FortiGate product and service revenue growth was 16%, and benefited from record levels of billings for our secure SD-WAN solution. To a large extent, our second quarter revenue growth, together with the backdrop of the COVID-19 pandemic, affirms the benefits of our diversification across geographies, customer segments, and industry verticals. At the same time, it illustrates the level of revenue predictability in our business model. Our continued growth in this environment It's a result of our strategic internal investments made to expand our global sales force, invest in our channel partners, and extend our cost for performance advantage as we update our product offerings and penetrate adjacent security markets. Product revenue grew 12% to $212 million, benefiting from strong demand for secure SD-WAN, high-end FortiGates, and FortiGate virtual machines. Our work-from-home solutions continue to provide a tailwind to growth. Our growth rates and industry reports suggest we continue to take market share in both the firewall and SD-WAN markets, markets where we have contributed leadership and innovation. Moving to service revenue, service revenue grew 22% to $404 million, representing 66% of total revenue. Over 90% of service revenue was from deferred revenue at the beginning of the quarter. It continues to support our revenue growth and predictability. 40R security subscriptions revenue increased 22% to $223 million. 40Care technical support revenue increased 22% to $181 million. The revenue mid-shift from 8x5 support to our higher price 24x7 support was 9 points. with 24 by 7 support now representing 64 percent of the mix. The shift to billings, total billings increased 14 percent to $711 million. The total billing growth was negatively impacted by approximately two points by training and professional services and other miscellaneous products, which are products not classified as FortiGate, Fabric, or Cloud. Earlier this year, we announced our decision to make our Network Security Expert, or NSE, online training and certification program free to the public. While this decision resulted in a reduction in training billings and training revenue, we're very excited about the demand we are seeing with our NSE training. As of this week, the number of NSE registrations for 2020 is well over 500,000, and the number of NSE certifications issued is up over 200 percent to nearly 200,000. Looking at billings by product segment, FortiGate billings increased 14 percent and accounted for 73 percent of total billings. FortiGate billings include our secure SD-WAN solutions, and as Ken mentioned a moment ago, SD-WAN passed over the 10 percent threshold for the first time ever, representing 12 percent of total billings. Non-forti-gate buildings also increased 14%, with strong demand from our virtual and work-from-home solutions, offset by smaller contributions from switches and access points, and as I mentioned, building declines for professional services, training, and other miscellaneous products. Our geographic performance aligned with the path of the pandemic, and with it highlighted the geographic diversification of our business. APAC, being further along, outperformed all geos, followed by Europe, while North America was impacted more. Our North America results include the United States, where we saw headwinds from the education and local government verticals, where the COVID-19 pandemic remained an issue. By comparison, the retail segment was by far and away the strongest performing U.S. vertical, with growth well over 40%, as we saw the continued expansion of the SD-WAN solution. The U.S. SMB segment provided strong growth, illustrating the strength of our U.S. channel programs, the remaining opportunity in this market, and solid execution by our channel partners and the Fortinet channel team. Looking more at the Americas, our analysis and discussions with our channel partners suggest that certain transactions were delayed into the second half of this year as these companies focused on their capital structure and other immediate priorities. Moving now to worldwide billings by industry verticals. The diversification of our business model was again on display, with our top five verticals continuing to account for about two-thirds of total billings. Worldwide government sector topped all verticals with 19% of total billings. Service providers and MSSPs accounted for 15% of total billings. Financial services, with 14% of total billings, hit a very strong quarter with billing growth of 33%. And despite COVID-related concerns, the retail vertical posted worldwide billings growth of 27%, accounting for 10% of billings as it continued to benefit from SD-WAN and the strong U.S. performance I mentioned a moment ago. We saw strong growth in retail sub-verticals, such as drugstores, groceries, and portions of the wholesale industry. At the end of the second quarter, total deferred revenue increased 24% to $2.3 billion, Short-term deferred revenue increased 24% to $1.3 billion. Looking now at deals by dollar size, the number of deals over $1 million increased 28% to 59%. Secure SD-WAN accounted for 13 of these deals over $1 million. This performance illustrates our continued ability to move up market into the enterprise segment and the continued acceptance of our differentiated, single-unit, secure SD-WAN offerings. Moving back to the income statement, as shown on slide four, gross margin improved 260 basis points to 79%. Product gross margin improved 340 basis points to 61%. Product gross margin continued to benefit from the lower cost structure of our newer generation of FortiGate products and over 40% growth in software products. Services gross margin increased 120 basis points to 88.5%, reflecting the benefit of the 40 care revenue mix shift to 24 by 7 support. Operating margin for the second quarter increased 370 basis points to 27.3%, benefiting from the improvement in gross margin and lower employee travel and marketing program expenses related to the shift towards virtual events. Total headcount into the quarter at 7,756, an increase of 23 percent, driven by the increased investments we've made to grow our business and reflecting a continued decline in sales and other attrition rates. With our continued growth, strong operating margins, and free cash flow, we do not anticipate any COVID-19-related layoffs in the foreseeable future. In fact, we plan to capitalize on our many opportunities by continuing to hire and invest in our balanced growth strategy. Given the strong operating income performance, net income for the second quarter was $135 million. Our earnings per diluted share increased 24 cents to 82 cents per diluted share. On a GAAP basis, we reported net income of $112 million, or 68 cents per diluted share, versus GAAP income of 73 million, or 42 cents per diluted share, a year ago. Moving to the statement of cash flow, summarized on slide 7 and 8. Free cash flow increased 21.5% to $216 million. The average contract term in the second quarter continued to be within the range we provided at the analyst day, declining one month year over year to 26 months and moving up one month sequentially. As we stated on the first quarter call, we expected to leverage the strength of our balance sheet as a competitive advantage to support our partners and our customers. Average contractual payment terms increased to 62 days, or 17 percent sequentially, in line with our expectations and reflecting our decision to provide geographically targeted extended payment term plans. Capital expenditures for the second quarter were $31 million, including $21 million related to construction and other real estate activity. We estimate capital expenditures for the third quarter to be between $50 and $60 million, and for all of 2020 to be between $165 and $185 million. Delays related to the new campus building have moved a portion of the previously expected 2020 capex spending into the first half of 2021. We expect full-year cash taxes to be approximately $40 million, and our full-year non-GAAP tax rate to be 22%. In the second quarter, we repurchased approximately 1.4 million shares of our common stock for an aggregate purchase price of approximately $146 million. In July, the Board authorized an additional $500 million for our share repurchase authorization and extended the term to February 2022. As of today, the remaining share buyback authorization is approximately $1 billion. Before moving to guidance, we wanted to offer some additional thoughts related to the ongoing COVID-19 pandemic. We have and we plan to continue leveraging the strength of our balance sheet, which may increase DSOs and inventory levels. The economic and business impact of the pandemic seems in line with the ability of different countries and geographies to reopen and avoid temporary shutdowns and uncertainty. For example, after strong buildings growth in April, We saw slower growth as we completed May, then followed by a bounce back to strong growth in June, and again strong in July. At the same time, the remaining Q3 pipeline points to a good level improvement in both the U.S. and worldwide. In the second quarter, our channel partners reported some deals being delayed into the second half of the year. The concept of delayed, not lost, seems supported by the increases in our pipeline, as well as the July selling activity. Clearly, there remains an elevated level of uncertainty about future pandemic events and economic conditions. As we look forward, I'd like to review our outlook for the third quarter, summarized on slide 9, which is subject to disclaimers regarding forward-looking information that Peter provided at the beginning of the call. In the third quarter, we expect billings in the range of $705 million to $730 million Revenue in the range of $630 million to $645 million. Non-GAAP gross margin of 78% to 79%. Non-GAAP operating margin of 25.5% to 26.5%. Non-GAAP earnings per share of 76 to 78 cents, which assumes a share count of between 168 and 170 million. We expect a non-GAAP tax rate of 22%. For 2020, Due to the continued uncertainty associated with the economic impact from the COVID-19 pandemic, we are not issuing full-year guidance at this time. And finally, along with Ken, I'd like to welcome all the team members who have joined us, including the Opaque team. I'd also like to thank our partners, customers, and the Fortinet team for all their support and hard work during these difficult and unique times. I'll now hand the call back over to Peter to begin the Q&A.

Thank you, Keith. Chris, if you'd like to open the line for questions, please.

Thank you. And as a reminder, ladies and gentlemen, to ask a question, you'll need to press star one on your telephone. To withdraw your question, please press the pound key. Please stand by while we compile the Q&A roster. And our first question comes from the line of Rob Owens with Piper Sandler. Your line is now open.

Great, and thank you guys for taking my question this afternoon. I wanted to start on the SD-WAN side of things and the success that you're obviously seeing there through the metrics, now over 10% of billings, but Just what that pipeline looks like. Have you seen more of a rush given COVID work from home and the opportunity to replace a lot of these solutions relative to branch types of solutions? Or are you seeing as much of robust demand, I guess, in that forward pipe? Thanks.

I think it's a long-term benefit for both enterprise and also SMB. And because it also lowered the lower the cost of connecting to the Internet at the same time, make it more efficient. And for us, also, building with the ASIC security together, so they can also have additional security, additional benefit, and cost much lower compared to some other competitors. So the market grow about 50% year-over-year, so we see a lot of potential, a lot of pipeline. We do believe we're keeping gaining market share because our solution is huge. very unique, huge advantage compared to other competitors. And with additional sales capacity we added, like we add HICOM 23%, even during the pandemic, take a little bit more time to train the new sales people, and then they maybe take a little bit more time to gain a new customer, but we do see a huge potential going forward.

And then secondarily, I guess, focusing on the SASE opportunity and some of the dialogue from previous calls, maybe you could touch on the opaque acquisition. Was this customer-driven? Was this opportunistic from your perspective, offensive, defensive?

We have this 40 SASE, like I mentioned, even in the last time, the earning call. And we do believe it's a part of the whole infrastructure. So this is a cloud delivery. We already have some other cloud delivery, but OPAC definitely keep enhancing this and we're making more broad, more flexible for customer, for the partner to leverage the product infrastructure we're building. And so we do see this is really enhanced the offer we have. And at the same time, we do have the broadest offering both on the platform and also on the on the function and also on kind of different form of deployment. Other competitors we see is keeping hands-on position.

Great.

Thank you very much.

Thank you.

Thank you. And our next question comes from the line of Fatima Bulani with UBS. Your line is now open.

Good afternoon. Thank you for taking the questions. Ken, maybe a bigger picture question for you. You know, the combination of SD-WAN adoption in a more durable work-from-home environment maybe is giving investors the sense, and perhaps it's misplaced, but giving investors a sense that the traditional enterprise branch office is potentially at risk from either a refresh footprint perspective and a cannibalization perspective. So I'm wondering if you can help us parse through sort of some of the puts and takes as to what happens to your branch office footprint and what some of those misconceptions might be as customers adopt SD-WAN and or stay at home or permanently in shelter-in-place situations. And then I have a follow-up for Keith.

Yeah, the enterprise also including some branch office, we do see some slowdown, especially in the U.S., but on the other side, If you look at our product, which come out like the SOT4 come out one years ago, we started building the product like from 100F to 60F with 40F, then we just announced the 80F last week. So we can see the run pop, especially in the SMB, including the U.S., they go up like over 40%. It's very, very strong. international a little bit behind on the U.S. to adopt some new product, including some both the low-end UCS24 and also the high-end MP7, which starting release about like early this year, so starting to ramp up. So that's where we see the benefit of the new product, which easily have a performance like four or five X better and the same cost, which we use in the, we call secure computing region. to benchmark compared to the other competitor is a huge advantage. So we see when we have the new product, the growth setting come up more quickly after the testing, you better adopt the product. But on the other side, the SD-WAN also gives an additional cost benefit together with the new product cost performance benefits. So that's what's helping driving the SMB we see starting growing quite well. And also last quarter after we announced the high end product like one to two quarter we started to see the high end also starting to leverage the MP7. So that's the trend. And I do believe sometimes enterprise take a little bit more time during this pandemic to do some deployment. But we do see a lot of evaluation going on. We do see some other. interest including combined we call security networking together, we call security-driven networking. So the whole infrastructure, that's where the sales probably were more engaged into the networking team and also traditionally more self-security. Now it's the networking team also starting to engage together with us to call the security-driven networking. So as we see the trend going on quite well and also like Keith mentioned, it's region by region. So it's an impact that grew up rather quickly, over 20%. And since the pandemic, kind of their situation may be better, recovered a bit better. And then we also see Europe probably also growing over 10%. The U.S. will be slow. But we do believe later this year, next year, that once things are over, with the new product lined up, with the additional sales capacity built, which will continue to invest, what we'll see of our strong potential going forward.

I think Ken does a great job of covering off some of the diversification considerations, whether it's by geographies and where different geographies may be, and also by verticals. But it's also important to note that SD-WAN is also a significant component of SASI and also for work-from-home solutions.

Fair enough. And Keith, since I have you, any comments on the billings performance specifically this quarter? And just double-clicking into FortiGate billings, because that includes both your traditional sort of network security, perimeter security, and the secure SD-WAN piece. I'm wondering if you can kind of qualitatively talk to sort of what drove the bus this quarter and how you're thinking about the secure SD-WAN versus non-secure SD-WAN performance FortiGate pipeline for the remainder of the year and what's baked into your 3Q guidance. And that's it for me. Thank you.

A lot of topics. Maybe I'll start with the last one. I know you do a good job. Look, I think when we look at the pipeline for Q3, which is what we've guided to, I think we feel very good about the SD-WAN opportunity. Clearly, we saw perhaps in the U.S. in the month of May a bit of a pause maybe some projects that were as we got towards the end of May. But clearly as we exited Q2 and we've moved into Q3, we can see that our customers are making plans to continue moving forward with their SD-WAN build-outs. And the additional opportunities that we see in the pipeline made us, let's just say, comfortable talking about crossing over that 10% threshold for the first time. Now we'll see how it actually comes into play. And I think I've lost track of some of your earlier comments. I'm sorry.

Fair enough. I'll get back in queue. Thanks so much.

Okay.

Thank you. And our next question comes from the line of Shaw Eeyore with Oppenheimer. Your line is now open.

Thank you. Good afternoon, gentlemen. Congrats on the quarter. Keith or Kent, so U.S. was the softest region this quarter. Next week will mark the middle of the quarter, the third quarter. Can you talk to us about the performance so far within the U.S., what the pipeline is looking like?

We do see some enterprise customer has a good interest about this SASE, and just like some other cloud or some other platform of deployment infrastructure, So that's where we make it as the whole infrastructure security offering. And the dollar or the amount of revenue, whatever, is still relatively small, which may not impact much of the total building of revenue there. But there's an interest about this and make it, so Cosmo want to make sure has some kind of a flexibility and also broad offering. So that's what we see is the OPEC acquisition keep enhance what we have on the 40 SAS here and also offer more broad, both on the product, on the deployment, on the infrastructure side to meet customer demand.

Yeah, and I would add to Ken's comment, just pulling back and looking at it even maybe a little more broadly and to the comments that were made and the prepared remarks, We're very pleased with what we saw in terms of July selling activity and the pipeline build worldwide as well as in the U.S.

At the same time, like we said, we're also keeping supporting our partner, including the service provider and even some big global customers. They also want to build in their own chassis just like the cloud. Sometimes they have the private cloud or the leveraged public cloud or the hybrid cloud. So it's a similar thing we're seeing here in SASE, which we're also supporting the partner and the customer try to have the version of SASE, which is based on the service of their trust infrastructure to deploy some security function.

Understood. Thank you so much for that. We'll talk later. Thank you.

Thank you. And our next question comes from the line of Sterling Audi with J.P. Morgan. Your line is now open.

Yeah, thanks. Hi, guys. You mentioned, you know, continued tailwinds from work from home, but we have seen the growth rate on the product side and to a certain extent, you know, the billings X, the adjustments you mentioned start to fade. So I guess my question is, do you expect that those trends can continue on for multiple more quarters or do we face further deceleration in the back half as some of the work from home, you know, tailwinds fade further?

We do see the enterprise service provider, the high end continue to grow, maybe because the new product is announced already this year. And also some SMBs, some other part also have very healthy growth. And also even some of the product target for work from home continue to grow in, like we mentioned for the tokens, for the authenticators, some other product. So it's probably not as a rush buy like we experienced in March, but it's still pretty strong above the hotel network security growth.

Okay, and then one follow-up. We've heard from multiple companies about accelerating digital transformations. How do the digital transformations and shift to the cloud impact your business either positively or otherwise?

Yeah, we see pretty strong in the retail, right? So if retail, they can order online, they can do whatever, deliver or some other, definitely they have a lot of benefit. So that's where we see very strong growth in retail, probably benefit from the digitalization. And some other vertical or even some other region have sort of similar things, and especially we expect That's what we call the secure-driven networking. It's combined security networking together. And even the sales, traditionally, they're more engaged with the security team. Now they see a lot of interest from the networking team, partially because IC1 is a part of FortiGate function, but other part they do see these two, the networking security, the working together, whether the NOC, network operating center, or the SOC combined together, it's also a trend there. So that's where we see quite a good progress combined security network together, which we designed from our beginning, not just SD-WAN, including the Wi-Fi. But actually Wi-Fi is a little bit slow right now because especially enterprise Wi-Fi in the office, not many people go to the office. But we do see a lot of interest in that direction. And also the 5G received very strong entries at Rampa.

Got it. Thank you.

Thank you.

Thank you. And our next question comes from the line of Brian Essex with Goldman Sachs. Your line is now open.

Hi, good afternoon, and thank you for taking the question. Keith, I was wondering maybe if you could hit a little bit more on billings, maybe a little bit softer than we had expected in the quarter and then, you know, kind of a nice, you know, guidance for next quarter. Maybe some of the dynamics behind that, and in particular, interested in, you know, large deal dynamics, particularly U.S. financial services, where we've heard about, you know, some weakness in the quarter. I understand retail is really strong, but maybe a little bit more color on that and how it might impact billings.

I think the financial services strength that we saw in the quarter was outside of the U.S. Obviously, New York got hit, or the Northeast got hit pretty hard with the pandemic in the second quarter. And so that financial services growth that we gave on buildings, I think it was 33%, that's really an international growth number, and it kind of speaks to the diversification of the business. We've talked before about our diversification, and that the U.S. represents maybe 25% to 30%. Obviously our largest country, but not a majority as it is with some other businesses. So we did feel the effect, particularly towards the middle part of the quarter there, with some of the things that were happening and the uncertainty in the U.S., on our total numbers, but we were very pleased with what we saw, as I said earlier, related to Asia Pacific and the rest of the world.

Yeah, the other part, really, starting my second half of last year, we started ramping up the hiring ad sales capacity, additional marketing, lead gen. And then the pandemic actually slowed down some of the new sales. I mean, become more productive or whatever. reach the productivity level for what we expect. At the same time, some of them maybe take a little bit longer time to reach the new customer. Especially in the U.S., we do have quite some sales and capacity. That's actually the pandemic slows things down a little bit. But with the additional hiring, with additional new position we have, we do believe once the pandemic starting to get better, especially in the U.S., we will see very strong growth potential.

Got it. Maybe, Keith, just to follow up quickly, nice kind of cash flow in the quarter, not better than we thought. Maybe some of the puts and takes outside of billings and change and deferred that drove that and outlook for the rest of the year, particularly from a working capital perspective?

Yeah, I think the other part of it is that collections were very strong, and I applaud the collections team. for the great job that they did working with our channel partners to bring the cash in. I think we were perhaps a little more successful in that than we planned. Yeah, I think when you look at our free cash flow numbers, you're going to get from quarter to quarter a little bit of volatility because we try not to overmanage the time of payments and things of that nature. So it's probably better to look at a couple quarters, stringing those together to look at terms. But in terms of the key drivers, yeah, it's billings. You can get something with inventory and payables. But I think the margin part of that really is a large driver. That outperformance on the margin line really manifests itself in many ways, one of which is in the free cash flow. Very helpful. Thank you very much.

Thank you. And our next question comes from the line of Hamza Fudarwala with Morgan Stanley. Your line is now open.

Hi, thank you for taking my question. Keith, I just wanted to dig in a little bit on the comments that you made around, you know, some of the sales cycles towards the end of the quarter. I'm wondering if, you know, how did those deal cycles progress towards late in Q2? What, if any, deals sort of, you know, had slipped out in Q3 and, you know, whether or not those have been closed so far in July?

Yeah, fair question. And I think the thing that we've seen with the pandemic, and I'll pull this up a little bit, if you go through the guidance setting process, obviously you start with the pipeline and then you start making certain assumptions about the close rate. And while we felt good, I felt good about what I was seeing in April, nonetheless, we made some adjustments to our expected close rate in the quarter for the second quarter. And as we got to kind of leading to your question, the last week of the quarter, I think we saw perhaps a few more deals that did not get the final signature that we expected them to get. And then your follow-on part of your question is, what are we seeing in July? And that's why I'm making the point that I think we're very pleased with what we're seeing in terms of July sales activity, whether you measure it based on growth or linearity against our target, as well as the pipeline, and as well as considering what we might call pandemic-related close rates.

Got it, got it. And just a follow-up question, if I may. On the government vertical, obviously that's a big one for you. Could you comment a little bit about how that grew from a year-on-year perspective and what you see the pipeline, especially with the, you know, U.S. federal close coming up?

Yeah, so keep in mind, our U.S. federal business, our federal business is, our government business, excuse me, has three components. It has a U.S. Fed, It has international governments and it has state and local governments. And I would say that the performance was strong across at about 26% growth, 25% growth, but that was not driven by state and local governments. State and local governments suffered. And then the U.S. Fed part of our business is not a huge part of our business. So you're really looking at while the U.S. Fed did well, we had nice, very attractive growth internationally with our government segment. Got it. Okay.

Thank you. Thank you. And our next question comes from the line of Brad Zelnick with Credit Suisse. Your line is now open.

Excellent. Thanks so much. You know, you guys continue to execute well, putting up better results than your nearest competitors. And the diversification of your business is on full display this quarter, which is great to see. Can you comment at all just in terms of the competitive dynamic that you're seeing out there and maybe anything that you can share in terms of the pricing dynamic as well?

Yeah, I think with the, like, 73% of beans come from 40K. So with the new release of, like, today's the high-end and most high-end product to support hyperscale. So we see the performance gap keeping increase. So we are getting much better and better. And at the same time, in the last few quarter, the ISOC-4-based, like, from 60F to 80F to 100F, 40F, is also starting to see huge, interest of growth in the field, especially you can see the SMB, they buy this low-end SOC-based product, also it's growing quite well. So that's where from the product we see, because we're keeping the invest long-term in this ASIC, which has a much better computing power handle security function compared to the general purpose CPO, so that we call it a secure computer region, come from like a 25 times better to like today's product is like 13 times better than the competitor. It's a huge advantage. And the plus additional function like SD-WAN and some other part. So we see it's quite a huge advantage and MoGap compared to the competitor, they probably will keep pushing some software or some other form of deployment. which because they have difficult time competing with us into this appliance or some other base. But for us also, we're positioned to have the whole infrastructure solution, not just appliance-based, but also in the cloud and in the software base and then also offer different kind of deployment and the service. We also see quite good healthy growth from that angle. That's where we call the fabric approach, the fabric solution. Revenue still like almost double compared to 40K growth. So we still see pretty healthy, like once you get in an average of 40K, then we can more easily expand into the other non-40K growth. So that benefit, the fabric advantage still keeping help us grow faster above average because it's really The consolidation is still the trend in the whole industry there. So customers want to reduce the management cost. They prefer consulting some of the vendors, which we suddenly see more benefit for us because most of the product function we do develop in-house, which make it integrate and automate from day one compared to some other competitive, dependent acquisitions, more difficult to integrate and automate. So that's what we see is a We continue to invest long-term, both on the product technology infrastructure side, and we do believe it's a long-term game. And so that's where we're keeping gaming market share, and we do see the gap getting bigger and we have more advantage right now.

Yeah, for us, Keith, I would continue on with Ken's comments there a little bit. And keeping in mind, I made a reference to it in the text that You know, we're seeing a new cost advantage evolve within the E-Series, and we expect it to continue with the F-Series. I mean, I think that the company, Ken, has done a tremendous job with the ASIC advantage of driving down the cost in subsequent generations of the chip, at the same time driving up the performance. That gross margin performance that I mentioned earlier in the script, that actually came with it with just a small headwind with discounting for the first time. And you may have been asking a discounting question. Discounting was the first time we've seen that in several quarters. about a half point, if you will, perhaps, increase in discounting. But that cost structure that's coming with the ASIC advantage that I made reference to is more than enough to outweigh that.

Thank you both so much for the very thorough answers. And I would just say that the competitive differentiation of your strategy continues to shine through. Congrats, and thanks for taking my question.

Thank you. Thank you. And our next question comes from the line of Walter Pritchard with Citi. Your line is now open.

Hi. Two product questions. First, just on the – I think last quarter you had some real strength in the remote access, things like authenticators and tokens. Just curious how that continued into this quarter. And then also on the SASE side, when are you talking about having an integrated SASE SD-WAN product in the market?

I'll take the first one. In very round numbers, I would say if I got a – A benefit of, call it very round numbers, $10 million in the first quarter, I probably got half that benefit in the second quarter on those three work-from-home products.

Okay. The SASE we're offering to the customer, to the partner this quarter, and it's part of what we call the February 40 SASE solution. And we do see the interest both from the existing customer, from new customer, and same time a lot of our service provider partner also very interested in this. And even some global customers, they also want to build their own version of SASE, which we are also supporting them behind.

Great. Thank you.

Thank you.

Thank you. Our next question comes from the line of Tal Liani with Bank of America. Your line is now open.

Yes. Hi, guys. My question is more general about the market. The data shows that the firewall market has been slowing down tremendously in the last few quarters, six or seven quarters of decline. What is your experience with the market? I'm trying to understand if your continued growth is a question of continued share gain or new products that are compensating for firewall weaknesses. What's your view of the overall market and the drivers for firewall demand in the market? Thanks.

The traditional firewall, they are most secure. We call the border, which is positioned between the internal network LAN and also the Internet. That part is, like I said, there's no longer enough. There's multiple ways you can bypass that and also a lot of – a lot of things also go beyond the company network. They go to the cloud or go to some other part like mobile access. So that's where the traditional firewall we do see the growth slow down. That's where we keep expanding beyond. Like we expand to the WAN. That's what we call security-driven networking. That's the IC1 built into the FortiGate and make it part of the WAN solution and also part of the cloud solution. And at the same time, Internally also expand, go to internal segmentation and like with a switch with a Wi-Fi access point. Now part also growing very, very well and quite strong. And so like I said, we keep saying now we say it's a third generation of a network of security infrastructure from the traditional connection-based to when we fall on 49, we call the content application-based. security, and now it's more like the whole infrastructure security, including both the traditional gateway and also go to the, you know, as I said, the one connection, the cloud solution, and the SASE, and at the same time go internal for the segmentation for the switch for the Wi-Fi. It's the whole, and plus the endpoint of different applications. So it's the whole infrastructure security we feel is a new trend which we prepare all this using a fabric, using ASIC, increase the computing power to address the network speed issue. We keep doing this for about 20 years since we found the company. So we suddenly see the investment we made whether from ASIC for the technology, for the product side, for the infrastructure side. study more benefit us and differentiate Fortinet compared to some other competitors still relatively, it's the same approach compared to the early day one that was security. So that's what we see is the gap and the advantage we have is kind of bigger and bigger going forward.

Got it. And the migration to SASE, isn't it going against your core offering?

No, it's a part of the whole infrastructure security. And like SD-WAN, because for the SAS, it's really, you need access to it, right? So that's where SD-WAN and other parts really have a good way to access that. So we are building into the 4DK and has huge performance and functionality advantage. And at the same time, the service model leverage, the infrastructure we have, the customer base we have, that's where the OPAC acquisition happens. keeping enhanced this part. So that will be address some of the new things the customer needs. And at the same time, the partner also see how we can like working closely with them to supporting the customer better, give them the additional flexibility no matter what kind of format of security deployment they want.

Got it. Great. Thank you.

Thank you.

Thank you. And as a reminder, ladies and gentlemen, to ask a question, you need to press star 1 on your telephone. And to withdraw your question, please press the pound key. And our next question comes from the line of Amit Daryani with Evercore. Your line is now open.

Good afternoon, guys. Thanks for taking my questions. You know, I guess first one, you guys mentioned a couple of times about certain deals just getting pushed out from June into the September quarter. Any sense you could give in terms of the deal size or the verticals where you saw this happening? And I guess if you didn't have any of these issues, what would the June quarter revenue look like?

I don't know that there was a common theme. Well, first of all, large deals for us would be $1 million, right? They're not $10, $20, or $30 million deals. So you're probably looking at some number of those transactions that moved. I don't know that there was a common theme in terms of verticals, if you will, I do think that it was a bit more of a challenge in the U.S. than it was in other geographies on that close rate for the last week of the quarter.

Got it. I guess, you know, last quote on this one, you've talked some amount about perhaps using your financial strength as a way to essentially accelerate your share gains. Could you just touch on what impact would that have on your free cash flow or even your margins perhaps? trying to get a sense of how much you're willing to flex your model and what sort of sharing and aspiration would you have from these dynamics that you would take on.

Yeah, there's probably three places that you could see it. One is looking at the inventory because we're, in this environment, we'd like to keep a little more inventory on hand. And so when you look at the inventory turns, I think the number was 2.2 in the quarter, and that's probably down about one. And so you can do some math there and quantify it. You can also look, the second place you would see it is on the extended payment terms. We provide the metric of what our contractual payment terms were as of the end of the quarter, which I think was 67 days, and that's up 17%. The third place that we can flex a little bit is on discounting, and I kind of covered that a moment ago, that while discounting in the current economic environment is a fact of life, and we did have a slight increase in discounting, for us it was outweighed by the structural differences in our cost structure, which more than outweighed it. So in terms of flexing our balance sheet and looking at the cash flow model, if you will, I think the key place is inventory and then looking at the collections.

And just one correction on the contractual payment terms. It was 62 days.

I'm sorry.

Perfect. Thank you.

I'm happy. I'm happy it's only 62. Thank you.

Thanks.

Thank you. And this does conclude today's question and answer session. I would now like to turn the call back to Peter Salkowski for closing remarks.

Thank you, Chris. I'd like to thank everyone for joining on today's call. Fortinet will be attending the following virtual investor conferences during the third quarter. We'll be doing the Oppenheimer Conference next week on August 11th, the Citibank Conference on September 9th, and the Collier Securities Conference on September 10th. Event presentations will be webcasts, and links for these webcasts will be available on the Investor Relations website of the Fortinet IR site. If you have any follow-up questions, please feel free to contact me. Have a great rest of your day. Thank you very much. Have a good day. Take care.

Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect.