Fortinet, Inc.

Welcome to the third quarter earnings call. I would now like to hand the call over to Peter Salkowski. Please go ahead.

Thank you, Michelle. 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 financial results for the third 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 by providing a high-level perspective on our business. Keith will then follow that with a review of our financial and operating results for the third quarter before providing guidance for the fourth quarter of 2020. We'll then open the call for questions. During the Q&A, 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 those forward-looking statements are subject to risks and uncertainties. which could cause our 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 stated otherwise. Our gap results and gap to non-gap reconciliations is located in our earnings press release and in the presentation that accompanies today's remarks, those of which are on our industrial relations website. Lastly, all references to growth are on a year-over-year basis unless noted otherwise. I'll now turn the call over to Ken.

Thanks, Peter, and thank you to everyone for joining today's call to review our third quarter 2020 results. We are very pleased with our third quarter performance. building increased 20% to $750 million. Our SD-WAN solution more than doubled year-over-year and represents over 13% of total buildings. Total revenue increased 19% to $651 million, with product revenue growth accelerating quarter-over-quarter to 14% and service revenue up 22%. Recently, Fortinet was the only vendor recognized as a leader in both the latest Garland Magic Quadrant for one-edge infrastructure and quantum magic quadrant for network firewalls. Fortinet's FortiGate SD-WAN is the only organically built solution that provides networking and security integrated into a single appliance that delivers leading protection, performance, and cost-saving for the largest customer base and fast revenue growth among major players in the space. The COVID-19 pandemic has accelerated digital transformation. An organization has to deal with new challenges to secure the whole infrastructure in a zero-trust environment, whether it's a WAN, cloud, data center, network, branch, or home edge. Fortinet is helping customers solve these issues through security-driven networking and a platform approach. FortiGate Security Fabric, which combines networking and security across the entire Connect environment, provide protection whether on-premise, virtual, or cloud-based environment. A recent Fortinet survey of cybersecurity leaders showed almost 70% of organizations are concerned about inside threats. Today, Fortinet announced the FortiGate 2600F for enterprise-level internal segmentation and hyperscale data center in multi-cloud environment, powered by the new MP7 security processor The FortiGate 2600F offered the highest performance with a secure computer reaching up to 10 times higher than our competition. Garner has stated that over the next few years, edge and immersive technologies will begin to replace cloud and mobile. The release of a seven new appliance for the ASIC SPU together with cloud and software-based virtual machine could replace security anywhere. We're unable, Fortinet, to capitalize on this investment and we'll feel our growth going forward. Before turning the call over to Keith, I would like to thank our employees, customers, partners worldwide for their continued support to manage our response to the ongoing COVID-19 pandemic.

Keith. Thank you, Ken. Let's start the third quarter review of revenue. Total revenue of $651 million was up 19%. Product revenue of $224 million was up 14%, benefiting from strong demand for secure SD-WAN, high-end FortiGates, and cloud solutions. Service revenue increased 22% to $427 million. FortiGuard service revenue increased 22% to $235 million. FortiCare service and other revenue increased 21% to $192 million. The revenue mix shift from 8x5 to 24x7 support was 11 points, with 24x7 now representing over 65% of the mix. Moving to the mix of FortiGate and non-FortiGate revenue, FortiGate product and service revenue increased 16%. Non-FortiGate product and service revenue grew 27%, driven by growth from cloud and fabric solutions. Given the continuing strong growth of our non-FortiGate or fabric platform, it's worth noting the absolute size of this business. For example, during the trailing 12-month period into September 30th, 2020, non-FortiGate products and services totaled $668 million, an increase of 26.5% when compared to the previous 12-month period. and solutions include a complete range of form factors and delivery methods, including physical and virtual appliances, cloud, SaaS, and perpetual software, as well as hosted and non-hosted solutions. Combined with our FortiGate business, we offer our customers the needed range of security solutions and form factors, enabling them to provide security across their entire IT infrastructure, whether it's at the WAN, cloud, data center, network branch, or even home office edge. Our third quarter performance illustrated the benefits of our diversification across geographies, customer segments, and industry verticals. Looking at revenue by geos, as with the second quarter, our geographic revenue performance aligned with the economic impact of the pandemic and with it highlighted the geographic diversification of our business. As summarized on slide five, revenues in Asia Pacific increased 27.5%, as many Asian countries and economies have been able to remain largely open. Revenue growth with Americas of 13% continued to reflect the impact of the pandemic, especially in Latin America, as well as a very difficult year-earlier comparison. Revenue growth with Americas in the third quarter of 2019 was over 24%, the highest of all three geographies. If we shift to billings, total billings increased 20% to $750 million. Looking at billings by solution segment, FortiGate billings increased 16% and accounted for 72% of total billings. As shown on slide six, high-end FortiGates posted strong billing growth in the quarter. Non-FortiGate billings increased 29% the strong demand for fabric and cloth solutions. As with revenue, our billings performance by geos aligned with the economic impact of the path of the pandemic. APAC billings outperformed all geos, followed by Europe, and then the Americas, including Latin America. Now turning to billings by customer segments. As we experienced in the second quarter, we saw solid billing growth in the SMB and large enterprise segments. SMB posted strong growth across all geos, illustrating the strength of our channel programs, the solid execution by our channel employees and partners, and the large, diverse makeup of this multinational customer segment. Moving to worldwide billings by industry verticals, our top five verticals continue to account for about two-thirds of total billings. The worldwide government sector topped all verticals at 20% of total billings. and grew it over 40%. We experienced solid performance internationally and in the U.S. at the local levels. Service providers and MSSPs accounted for 16% of total billings. Financial services, with 14% of total billings, also had a very strong billings growth quarter at 27%. Education, with 90% of total billings, rebounded in the third quarter as schools prepared for secure e-learning in the fall semester. Now looking at deals by dollar size, we had 48 deals over $1 million in the third quarter, compared to 53 deals in the third quarter of 2019, and 30 deals in the third quarter of 2018. Secure SD-WAN accounted for seven of the deals over $1 million, and while down from eight deals over $1 million a year ago, total SD-WAN billings more than doubled, and as Ken mentioned, accounted for approximately 13% of total billings. Moving back to the income statement, as shown on slide four, gross margin improved 130 basis points to 79.5 percent. Product gross margin improved 220 basis points to 62.9 percent. Product gross margin continued to benefit from the lower direct costs of our newer generation of Florida Gate products, offset slightly by higher indirect costs. It's worth noting that for five quarters in a row, including two pandemic quarters, product gross margin has been over 60%. Operating margin for the third quarter increased 90 basis points to 27.4%, benefiting from the improvement in gross margin and continued lower travel and marketing program expenses related to the shift towards virtual events, offset by the addition of new team members. Total headcount into the quarter at 8,075, a 23% increase given by the increased investments we've made to grow our business. Given the strong operating income performance, net income for the third quarter was $145 million. Enterings per diluted share increased $0.21 to $0.88 per diluted share. On a GAAP basis, we reported net income of $123 million, or $0.75 per diluted share, versus GAAP income of $80 million, or $0.46 per diluted share a year ago. The strong performance this quarter is the result of the diversification of our business and the strategic long-term investments we've made to expand our global sales force, to invest in our channel partners, and to expand our product offering and provide a truly integrated security platform enabling automation. Moving to the statement of cash flow, summarized on slides seven and eight, free cash flow came in at $186 million. As we commented previously, we are leveraging the strength of our balance sheet as a competitive advantage to support our partners and our customers as they experience the economic challenges of the pandemic. As a result, average day sales outstanding increased to 76 days, up three days sequentially, and 13 days year over year, in line with our expectations and reflecting our decision to provide geographically targeted extended payment plans. We expect extended payment terms and higher inventory balances to be in effect as we move through at least the first half of 2021. Inventory terms decreased to 2.1 times as we increased our on-hand inventory to mitigate supply chain risk. Capital expenditures for the third quarter was $35 million, including $26 million related to construction and other real estate activity. We estimate capital expenditures for the fourth quarter to between $40 and $50 million, and for all of 2020 to between $130 and $140 million. The lower full-year CapEx range is due to utilities and other delays in the construction of our new campus building that are pushing more spending to 2021. Our move-in date has moved to mid-2021. The average contract term for the third quarter was 26 months, flat year-over-year, as well as sequentially. We expect full-year cash taxes to be approximately $40 million and a full-year non-GAAP tax rate to be 21%. As we look forward, I'd like to review our outlook for the fourth quarter, summarized on slide 9, which is subject to disclaimers regarding forward-looking information that Peter provided at the beginning of the call. For the fourth quarter, we expect billings in the range of $890 million to 920 million. Revenue in the range of 710 to 730 million. Non-GAAP gross margin of 78% to 80%. Non-GAAP operating margin of 27% to 29%. Non-GAAP earnings per share of 95 to 97 cents, which assumes a share count of between 167 and 169 million. We expect a non-GAAP tax rate of 21%. Now, having said that, based on this fourth quarter guidance, we expect to achieve the rule of 40 for the full year, making 2020 the third consecutive year and the ninth year of the last 11 years that we've been able to achieve this milestone. So, along with Ken, I'd like to thank our partners, our customers, and the Fortinet team for 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. Operator, please open the call for Q&A.

Ladies and gentlemen, if you'd like to ask a question, please press star then 1 on your touchstone telephone. To move yourself in the queue, please press the pound key. Our first question comes from Brian Essex of Goldman Sachs. Your line is open.

Hi, good afternoon and thank you for taking the question and congrats on a nice quarter of results. I was wondering maybe if you could touch on what you're seeing in the spending environment. Particularly, it sounded like you had a really nice quarter of fabric growth and SD-WAN demand. We also picked up, you know, physical firewall strength in the quarter. So maybe, you know, from the standpoint of, you know, what you're hearing from CIOs and what actually, you know, surprised you the most about the demand in the quarter? Sure.

That's a good question. We also closely monitor watching the whole things change in the space. Basically, so that's where we keep promoting, we call secure driven networking and also that's the concept we try to, the thinking we have in the last 20 years. So you can see the, definitely the SD-WAN starting come to the networking side and probably in the next 10 years can grow over $20 billion. So that will be huge. We want to be the leader number one in the space. I hope target next year. And at the same time, the security is that the zero trust concept starting to get very popular. So we need to make the whole infrastructure very secure. And also the work from home also starting changing a lot. Like in early this year when the pandemic just started and people, enterprise just tried to see how IT can support your work from home. Now they're starting to try to see what's the long-term solution, whether it's some service-based or some other they call the the home is the new branch, right? So that's where you can have a 40-gauge install in the home, can manage much broader device, can also, like, property shaping, like, manage different priority for different application, different user, and at the same time can secure the whole infrastructure that sometimes they also call the SD branch solution. That's where manage the Wi-Fi, manage other switch, other networking equipment altogether, and also even the printer or the other home appliance. So that's what we're starting to see. Even some big enterprise or some working with water service provider, some companies starting to offer the employee or because they call them the new branch, they not only give them some kind of 40-day planning, but also including the Internet access, including like water 4, 5, 3, 4, 5G or some other thing altogether. It's kind of a package solution, and to help in security, they call that the whole infrastructure security. So that's why we see both kind of approach. So we closely working with service provider, whether through the service base, I see I'll do this kind of a whole infrastructure security approach, but the new branch, hold the new branch approach. So it's definitely changing the whole environment So the security no longer just security the gateway, the border, I mean we expect the whole infrastructure and same time the networking also need to be more application awareness like based on application like SD-WAN or some other based on the content like there's certain content CDN provided also starting getting a security space. So that's what keeping saying the security of the networking starting kind of ramp up quickly.

Got it. That's super helpful. Maybe just to follow up on that safety comment, any, and I know I'm going to mispronounce this, but any initial traction with OPAC or OPEC through MSSP channel and, you know, how much progress have you made, you know, with that relationship so far?

Yeah, we acquired OPEC last quarter, and we're working together to make it a whole solution for this. Also, we are very closely working with a lot of service providers because we do keep in saying for the few years, you see the service provider has the best position to offer a lot of service. So we help them, and also FortiGate is one of the best platform. They can build whether within their POP or even extend into the branch or extend to inside a company. So it's a good change in the space.

Got it. Thank you very much. Thank you.

Next question comes from Fatima Bulani of UBS. Your line is open.

Thank you for taking the questions. Keith, I have two for you. Just looking at your outlook and your billings guidance, I wanted to unpack that a little bit and get your sense of where you are being a little bit more cautious relative to the performance this quarter and how we should think about some of the puts and takes into the guidance that implies a deceleration from the third quarter performance you just put up. And I have a follow-up as well.

Sure. I think 2020 has shown to be a very interesting year for setting guidance. Q1 was very, very strong. Q2 was challenging. Q3 is a nice bounce back. You know, it's really a function of watching media reports almost on a daily basis in terms of what's happening with the pandemic, you know, what we see happening in the U.S. We can also layer into that the U.S. election, but also what we're seeing in Europe. And I think, you know, in the current environment, I think the guidance does a pretty good job of trying to reflect our current understanding of the pandemic.

Fair enough. And just a bigger picture question for you. As I think about the complexion of your 2021 margin profile, if I look at 2020, you are head and shoulders above sort of the 25% operating margin watermark that you've spoken to historically. So I'm wondering as we think maybe longer term over the next couple of quarters, What are some of the structural versus temporal impacts on the margin trajectory from here, you know, considering the pandemic tradeoff and some of the acceleration you've undertaken on the sales hiring front? I would love to parse through that out with you. That would be really helpful. Thank you.

Yeah, I think to kind of start top down on that, I think the product gross margin, and probably why we made reference to it in the call, being over 60% for, I think, five quarters in a row, You know, there were some periods of time there where it was probably in the higher 50s. You know, we like very much in terms of the structure that we're seeing, in terms of our pricing and our cost structure on gross margin. And even as we continue to introduce new products, hopefully we'll be successful at that 60% gross margin number. And as you kind of move your way down the income statement, I think it's really, you know, a sales and marketing conversation in terms of spending. Clearly, we're continuing to get the benefit of not having salespeople travel and not the financial benefit, excuse me, of having salespeople not travel as well as marketing programs being virtual. And to the extent that the world stays that way, we're going to continue to get that benefit. Now, obviously, and I think we've talked previously that, you know, we're very committed to use this as an opportunity to bring in more salespeople. We talked about our headcount around the 23%. You know, hopefully that we time this right such that when those newer salespeople are coming online and they're fully productive, we'll be around the time that, You know, they're adding to the top line at the same time. Travel and marketing programs revert to historical norms.

Appreciate the detail.

Thank you, Keith. Our next question comes from of Oppenheimer. Your line is open.

Thank you. Good afternoon, guys. Congrats on the performance and outlook. I had a question on the SD-WAN opportunity and given the ongoing strength you're seeing. Have you started to see some displacement opportunities given the potential disruption that one of your competitors, smaller competitors in the space, could be seeing given a consolidating market?

This can know we still see very strong interest and No competitor come close to what we have so we say that it's more than double year-over-year and also we're the only one has a Too much quadrant both when I see one found also the network firewall come to the same appliance and the same time as a It's a certain percent of last quarter's building, but we have a huge installation base. A lot of customers even enabled that one. We are not quite even confident on that one. So we believe we have a much bigger user base about like we call secure IC1 solution. And also going forward, I'd say that the work from home is also will be helping driving this, whether you treat home as a new branch or whatever. this kind of solution. So we feel we have a market position technology and also the only one built internal organically and also have ASIC to accelerate all the performance on average about 10 times faster than any other competitor. So that's where we see the huge opportunity. And the market grow like 50% year-over-year and we grow more than double year-over-year. We're keeping gaining market share.

Yes, I got it. I think Ken's spot on with that. I think if we look forward in terms of the opportunities, what Ken's referring to, I think there's still the opportunity in front of us to help the service providers unpack their existing relationship with their incumbents on the SD-WAN side, and that's something I think we're very focused on. And as we start to see that SD-WAN is a critical component of SASE and the cloud on-ramp, so I think, to Ken's point, that market's going to continue to expand for us.

Got it. Got it. That is super helpful. And maybe a question on the Americas performance. Keith, when you isolate the mixed Latin American performance and strictly focusing on the northern part of the Americas, how would you characterize the performance slightly more in line with your internal expectations heading into the quarter?

Yeah, I think the U.S., well, there's three components to the Americas. Latin America, which is a very difficult place currently And we saw that in the numbers. You know, we expect a difficult quarter over Latin America, and we certainly got that. Canada, on the other hand, has actually done fairly well throughout this. It's just a different footprint in terms of the pandemic. To your specific question related to the U.S., I think the U.S. did much better in the third quarter than it did in the second quarter. But clearly, I would not say that we're at pre-pandemic levels for the U.S. There's still opportunity there for us.

Got it. Thank you so much. Good luck. Good job.

Thank you.

Our next question comes from Brad Zelnick of CreditSuite. Your line is open.

Great. Thanks so much, and congrats on the acceleration of the business. It's great to see. My first question for you, Ken, I wanted to ask about the impact of 5G on your business. You know, it seems we're approaching a tipping point in terms of broader 5G coverage. So my question is, you know, how should we think about the benefits to your business and why you feel that Fortinet's competitively advantaged? as we approach this tipping point?

5G, so far, I see is more connected to the device than connected to the people, like the 3G, 4G in the past. And also, it depends on the vertical industry. And we're also needing a lot of OT, IoT security. But also, like, work from home could be also a good backup for this, like, one access. But it's, so we see quite a lot of successful case on international right now that seems more, they beat ahead on some of the 5G deployment and also working closely with the carrier service provider. Like I said in the last quarter earnings, it's kind of growing faster than we expected and probably still on a very small base, but we do believe next year could be material the 5G contribute for our growth.

Great to hear. Thank you. And for Keith, last quarter you mentioned that discounting had picked up for the first time in a couple of quarters. How do you characterize discounting, you know, in Q3 at this point? Thanks. Flat.

Consistent with what it was a year ago. Nothing to call out. So I guess the way to give that color, I think we felt a little more pressure in the second quarter. We did not feel that same pressure in the third quarter. Great to hear. Thank you so much for taking the questions, guys. Thanks, Ben.

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

Hey, guys. Thanks for taking my questions here. Keith, maybe first for you a housekeeping question. Can you just talk about some slight changes to the deferred revenue balance historically? You know, I know there's a footnote in the earnings slide, but maybe you could just expand on what the adjustment is and and how that impacted deferred and billings, just so that we're all on the same page.

Yeah, we had a little housekeeping to go through with a subset of our 40-care contracts. Historically, and this goes back many years, we probably should have been recognizing revenue a little bit sooner, starting the amortization period, than we had been. So there's a little bit of a pickup on quarterly 40-care service revenue. It ranges, it's very small. It ranges from a tenth of a percent to about a half a percent of revenue for any particular period. When we file the thank you, there'll be a long footnote that shows every possible period and so forth. But that's all, though. Just a little bit of housekeeping to pick up some revenue there.

Okay, got it. So just to be clear, the billings that was reported in the court of the 750, you know, that really wouldn't have been impacted by sort of that change, right? No, no, no. Okay, got it, got it. Understood. The follow-up for you, Ken, just on the product side, You know, I guess as opaque becomes a bigger part of the offering, how do you think about the strength of the FortiGate line that maybe helps differentiate when you're offering a SASE solution? Does that make sense?

Yeah, I think FortiGate is a very important part of SASE because they are the best firewall, SD-WAN, and all the other things. can be positioned within the POP or sometimes we can working with service provider to use it for decay to be part of their service, their solution there. And same time, we also do believe sometimes you also need to have a kind of a different approach like appliance can be in the home or can be in the branch or can be within the data center and the secure like East-West traffic. So that's where we see FortiGate as a larger platform to keep expanding the code, whether the whole infrastructure security or security-driven networking, including both inside SASE, POP, or all kind of secure other part of infrastructure.

Very helpful. Thanks, guys. Thank you.

As a reminder, to ask a question, please press star, then 1. Our next question comes from Sterling Oddy. of JP Morgan. Your line is open.

Hi, guys. This is Matt on for Sterling. Thanks for taking the question. You know, wanted to ask a little bit more on SD-WAN. I was wondering if you guys could, you know, give additional color on what you make of the competitive landscape currently and what you've seen on pricing on that front. Thanks.

Yeah, we offer the most that the best pricing, performance, and also more function SD-WAN and other competitors. And SD-WAN can see probably one of the fast-growing area, also one of the biggest market potentials. So there's a multiple research that would be reached over $20 billion in like five to 10 years, probably even bigger than the network security. And that's why also we want to combine these two together. So you see the same platform offer both. So that's where compared to other competitor, which is only the software approach or sometimes even to whether they call the universal CPU load in some other appliance. So we have this ASIC dedicated hardware and the plus like both in the low mid to high end range can be within the pop or go to the home branch or go to within the data center inside the cloud. So that's where we see the huge advantage compared to other competitors and also from the magic quadrant from the growth we have. And we do believe we'll be the number one leader in this space.

Yeah. Matt, I can spot on with that. I think he's probably being a little bit humble because I think really what's going on is because of the ASIC strategy and what he's built, he's been able to increase the capacity in the firewall virtually each and every year. And it's a matter of how you use that capacity. Different SD-WAN vendors have different pricing methods, but for Fortinet, you know, it's embedded in the operating system of firewall. We do not charge for it separately. When you purchase a firewall, you receive the SD-WAN functionality. So I don't really think that, and certainly we do not see anything in terms of our discount, as we talked about, that suggested any sort of change.

Great. That's very helpful. And then just one quick housekeeping question. So going back to Socket's question, on billings, if we just take the change in deferred on the balance sheet and the revenue, it seems like there's a disconnect to that in what you reported on billings. I was wondering if there was anything there to kind of unpack.

No, I don't think so. I mean, it's a pretty darn good definition, and billings is really defined as being revenue plus or minus a change in deferred revenue, unless you have an acquisition or something like that. There should not be a difference there. Okay. Thanks, guys. Thank you.

Our next question comes from Andrew Nowinski of G.A. Davidson. Your line is open.

Great. Thank you, and congrats on a nice quarter. So you called out strength in high-end billings this quarter, but it's actually been very strong for the last three quarters, which is somewhat surprising given that we're in the middle of a pandemic. So can you just provide any more color on what's driving that consistently strong growth in high-end?

There's some really to the new MP7 because it's compared with MP6. They're improving the performance by almost 5X, and also now can process like a 200-gig traffic per chip compared to the 40-gig. and also more function there. So that's where we started to roll out the new MP7 base. MP7 probably only go to the high end and middle range. And at the same time, we do see certain vertical also help to add some high end, like a finance service, some government sector, which they're mostly by the high end, which has a less impact by the pandemic. Maybe Keith has other thoughts.

No, I think I would point to 1100E, or 1100F, excuse me. Yeah. The product has been out there for about a year now, and it's done very, very well. It performed extremely well in the third quarter, and I think it's been ramping up, as we expect typically of the high-end products.

Yeah. Also, SD1 is probably half of the product comes from the high-end contribution.

That makes sense. Thank you. And then... Why do you think you saw fewer $1 million deals this quarter, given the strength in the high-end billings that we've seen?

Yeah, I think that's a very good question. We came into the quarter looking at the pipeline and actually had a little bit of risk, I thought, because we had a larger mix of larger deals. And then when we got through the quarter, obviously the mix actually shifted on us a little bit. I mean, we've all read reports that maybe – In general, the deals are getting a little bit smaller, what have you, and maybe that has something to do with it. I really don't have good information in terms of why, what ended up, I mean, what you get every quarter always differs from the pipeline. I don't know why that particular item differed this time.

Yeah, but the deal over 500Ks increased a lot, right? And also compared to one year ago, Q3, Last year, we grow the – one year ago, we grow one million deal quite a large number. So that's where it's more comparison.

Yeah, and Ken makes a very good point. In fact, if you look at deals over – SD-WAN deals over $250,000, those were up well over 200% year-over-year.

That makes sense. Thanks, guys.

Our next question comes from Hamza Fadawalla of Morgan Stanley. Your line is open.

Hi, guys. This is Calvin Patel on Ferranza. Congrats on the quarter, and thank you for taking my question. I was wondering if you could first comment a bit more on invoice durations and how you see that trending in your more recent conversations as we go forward.

Invoice duration? I'm sorry, was that the question? Yeah. We've been right at that. Despite what maybe some other competitors expected to see a year, year and a half ago, I think we've been very consistent throughout that timeframe at about 25, 26 months.

All right, perfect. And then just as a follow-up, if you could comment a bit more on the competitive landscape in firewall this time, not just in the SD-WAN segment, and if you think that there will be some level of digestion to occur over the next year or not.

We're keeping gaining market share quickly in the firewall market, but also I believe going forward, we've been saying this for a long, long time, almost since the beginning of restarting the company 20 years ago, so that the new networking will be more secure-driven. So instead of the networking routing switching all about connectivity and speed, they need to make sure they can deal with application, and that's where ISD1 is application-based routing networking, and also they can deal with all the content and also user device level. That's all security handling. So that's where we see probably the traditional, whether the traditional network security, which is on the security border, or the traditional networking probably also needs doing some transition change So the network security is still about $20 billion market probably, and the traditional networking may be $70 billion, $80 billion market, but there probably will be starting merging and transitioning and changing. We feel we're leading this changing, and we're also in a market position, market technology, to really address the new security-driven networking.

Thank you, guys.

Thank you.

Our next question comes from Rob Owens of Piper Sandler. Your line is open.

Hey, guys. This is Justin. I'm for Rob. I just had a quick one on the federal government vertical strength in the quarter. Just tell us trending relative to your expectations and maybe if there is anything that we can unpack on what drove the strong quarter.

Yeah, it's not. If you go back and look at the phrase very closely, we're not talking about U.S. federal. We're talking about government, which for us is more international government as well as local governments. U.S. Fed is not a large part of our business.

Got you. And then also just a quick follow-up, maybe just on your pipeline relative to where it's sitting now relative to last year and how you feel going into the fourth quarter just given it's usually historically your biggest.

Yeah, well, pipeline is probably the biggest input to the guidance setting process, right? And there's all kinds of different ways of slicing and dicing it, and we go through that, whether it's deal size, whether it's new logo versus an existing customer, whether it's a new deal versus a renewal deal or what have you. And I think clearly that the pipeline supports the guidance.

Got it. Thank you.

Our next question comes from Patrick Cole, Deutsche Bank. Your line is open.

Hey there. Thank you for taking my question and congrats on a very impressive quarter. Can we just talk about SD-WAN again? The result you guys put out was super impressive, doubling of growth year on year. We've been hearing the media and our checks around some firms kind of closing or rationalizing like branch offices. So clearly that hasn't had any effect on your business. But can you just talk me through – Yeah, whether, you know, you've heard that amongst your customers or anything related to that point would be great.

Yeah, because it's a huge benefit for what enterprise or some other, like, customer, even including the home user consumer to use in IC1. It's an average cost, probably more than 50% cost saving. And also they offer, like, how to manage multiple links among different kind of, like, application and because the fixed connection whether the MPLS or some other one has a difficult time to manage like different application based on different cloud or kind of a different dynamic environment. So SD-Wise technology they can manage a traffic based on different application or even different content or some other security need as FortiGate doing. It's a huge benefit for the user. That's driving the growth even during this pandemic. And also we believe the long-term work from home can also quickly expand into a lot of consumer home user base. And to try to improve in the service supporting level from that angle, we should be working with a lot of service providers and big enterprise right now. But as a long-term, we do believe they may change in the whole networking space. It's just like whether you solve or define whatever application or content-based networking, which can offer a lot of additional benefit compared to the fixed networking or kind of VPN access. So it's got a lot of customer interest. That's the reason the market grew like 50%. and believe probably, I don't know how long, maybe 10 years or could be shorter or longer. Eventually, we do believe half or majority of the whole networking space may be this kind of SD-WAN approach to base on application content without a traffic.

That's very clear. I mean, one of the points you made was around... I guess the devices at the branch office. I mean, how often does the FortiGate SD-WAN solution sit alongside a traditional router? And how often is it a replacement of the traditional router?

We only need one FortiGate to replace all the router, all the security, all the Wi-Fi access controller, all this kind of thing. It's a single device. It has a multi-function. It can replace like a 345 device. including router, including the SD-WAN, and including the security gateway VPN, and also the Wi-Fi controller.

And just a clarification, is your point that in most cases FortiGate is a replacement for those devices?

Yeah, replace multiple devices altogether and become only device stay there.

Got it. Thank you so much for your time. Really appreciate it. Thank you.

Our next question comes from Gray Powell of BTIG. Your line is open.

Hi, this is Stefan on for Gray. Thanks for taking my question. Piggybacking off the last question with the branch office, have you seen any meaningful change in demand or mix of growth between the branch office and data center firewalls?

Yes, that's where you can see sort of vertical, whether retail or whatever, we still see pretty strong growth. I think, I believe, maybe 40%, something like that. And also, the bigger potential is really the home is the new branch. So that's where probably even bigger. But that's still in early stage because you still need to... helping the home user to manage some of that. I know a lot of service providers right now are working with us, but at the same time, certain enterprises also try to do that.

Thanks. And as a follow-up, can you just talk about the linearity that you saw in the third quarter? There was the mention of deal delays in the U.S. Did those end up landing this quarter?

I think you're talking about deals from Q2 that delays. Did they come in the third quarter? The answer to that would be yes. We were pleased with what we saw. But we were pleased with what we saw in July in terms of the start that we got on the quarter.

All right. Thank you.

Our next question comes from Adam Tindall of Raymond James. Your line is open.

Hi. This is Alex Frank. What's on for Adam? Thanks for taking my questions. I just wanted to touch on SD-WAN one more time. I was wondering, you know, how important is your ASIC in bake-offs? You know, how important is that performance boost to customers? And on SD-WAN, are you finding that it's becoming more of a driving factor in purchasing decisions, or do other, you know, core capabilities and functionalities come first when a customer is making a decision?

Yeah, the ASIC gives them, like, almost 10x more computing power, so that's where they can add, like, a security function, manage other, like, Wi-Fi, some other device and same time can process traffic much quicker and can also like working with service providers, some other one, make sure it's a total infrastructure secure solution. So that does a huge advantage compared to the other software approach which they have a very limited CPU computing power to manage whether security or SD-WAN or some other like the platform which can only handle single function compared we build this for the ASIC, it was for the OS, can handle multi-function, replace multiple device. So that's what we see is a huge advantage.

Okay, thanks. And then just to follow up, you know, looking ahead, you know, more than just a few quarters, you know, looking kind of a couple years out, what kind of, you know, rule of 40 margin profile are you targeting? You've focused solely on, you know, top line growth or, you know, do you expect – do we expect to see some margin drop through to the bottom line? Yeah.

I'm managing Ken very closely. He's managing me very closely. You know, we talked about our mid-term range of being – you know, we want to have 25% operating margin, right? The strategy remains the same, balancing growth and profitability. We started the year believing that we would tilt towards growth. As we went through the year, I think the pandemic obviously impacts the ability to grow in a couple of those quarters. But longer term, we still believe it's a balanced strategy towards balancing possibility and growth. We do believe there is an opportunity for growth, no doubt about it.

Okay, perfect. Thank you, guys. Thank you.

Our next question comes from Fatima Bulani of UBS. Your line is open.

Thank you, gentlemen, for allowing me to hop back in. I wanted to double back on the billings questions earlier on. The calculated billings based on your deferred revenue disclosure and disclosed reported revenue sum to $720 million in the quarter, and so I just wanted to appreciate that. $30 million delta between what you have in the press release and in the reported numbers and calculating the billings off the balance sheet deferred revenue metrics.

Sure. When you have some housekeeping going on, Fatima, I'll jump into this, Keith. You can have one of three things. You can have something that's so small you just want it to be in the current period. You can have something so large that you restate the prior period financial statements. You can have something in the middle, which is called a little R, where you're going to be cash financials. That's what this is. That $30 million when you see the 10Q will come out of the opening retained earnings back in December 31 of 2017, I believe it is. And it's from that point forward that the amortization starts being corrected. So internally, we have the information for you to actually track right now with the billing recalculation of that. You need to see Q2's number as recast, right? And that's not in the financials that you have, right? So $30 million came out of deferred revenue three years ago for something that's been going on for many, many years on this small transaction type. And it finally became large enough to correct, right? The number that we've reported is based upon recast revenue and recast deferred revenue, the balance.

Fair enough. So it's essentially a cumulative impact that we'll see the details for in the filing.

Yes, and that's why I gave the quick soundbite earlier that the quarterly impact revenue typically runs for each of the quarters that we looked at between a tenth of a point and about a half point of revenue. It's a very small item in any one quarter.

Understood. That's very clear. Thank you. And since I have you, Ken, a question for you just around the SD-WAN discussion. From a product standpoint, I think there's a debate that's brewing between the thin-branch architecture versus a thick-branch deployment architecture within the SASE paradigms. So I'm wondering how Fortinet is positioned in the former, so in the thin branch arena, if we think about the thick branch environment maybe under potential duress in an increasingly uncertain macro environment. And that's it for me. Thank you.

I think both branches can fit into different environments. The thin branch sometimes can solve certain mobile device issues. And the SIG branch also can process the things locally in the real time. A lot of applications need that. So the FortiGate is more like a pub in local, whether in home or whatever, in the office, or a city, the pub in a SASE environment, which you can see how they process the traffic within the SASE infrastructure. That's how FortiGate is the key point to really get this processed. So that's also because we have a huge computing power advantage over other approach, which give us a kind of much better performance, also lower cost. So that's where we have the flexibility, whether through the appliance and on-premise or can be the virtual fitting of the cloud or be part of the POP SASE solution. So give us the flexibility and also can extend beyond some other competitor, other player can do, which because if they're only limited for the software approach, they can only sit in certain server within a pop-up, within a data center. So we can extend beyond, go to the edge, go to the home, and go to a lot of even other remote locations. And that's also kind of, using my quote from the Gartner, it's really, so in the next few years, that's where, come from the Gartner research, they say that the edge and the immersive technology will replace in the cloud and mobile. So that's where you see you need to have more computing everywhere in the real-time application environment. So that's where we develop this ASIC and all this different technology to working with all different service provider or different kind of vertical space to address this issue, especially the infrastructure keeping changing with the 5G with all these like that. So the ASIC study have more advantage compared to the software-owned approach.

Very clear. Thank you so much, Kim.

Thank you.

Our next question comes from Patrick Colville of Deutsche Bank. Your line is open.

Hey there, I'm copying Fatima and hopping back in. Appreciate you letting me ask another question. How much did the Gartner's inclusion of Fortinet in the top right corner of the SD-WAN MQ influence customer decision-making? You know, this time a year ago, you guys were just outside of the top right corner, and now you are in it. And so was that something that... in your opinion, might have changed the dialogue a bit and, you know, got a focus on more RFPs?

It's helped on certain enterprise, but we also have much broader sector and also the geo-diversity is probably not dependent too much on the magic quadrant. But it's a, we also have a, like, because, like, the new magic quarter only come up end of the quarter. It's come up in September 30th, the last day of the quarter. So I don't think that's so.

We don't close that fast?

Yeah. So I don't think we can get that much goodness in the last day of the quarter in Q3. But it's, yeah, it's helping probably more going forward.

We certainly expect it's going to be. Yeah. helpful in the tailwind for us going forward, yes.

Great. Thank you so much. Thank you.

If there are no further questions, I'd like to turn the call back over to Peter Stalkowski to close your remarks.

Thank you, Michelle. I'd like to thank everyone for joining today's call. Fortinet will be attending conferences, by the way, attending conferences in the fourth quarter, Credit Twist conferences on November 13th as well as December 2nd. Irene and James' conference on December 7th, a UBS conference on December 8th, and a Barclays conference on December 9th. Events with presentations will be webcast, and the links will be available on our website, the Investor Relations website of Fortinet. If you have any follow-up questions, please feel free to contact me. Have a great day. Thank you very much. Take care.

Ladies and gentlemen, this concludes the conference. You may now disconnect. Everyone, have a great day.