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spk15: Good day and thank you for standing by. Welcome to the Fortinet Second Quarter 2021 Earnings Call. At this time, all participants are in a listen-only mode. After the speaker's presentation, there will be a question-and-answer session. To ask a question during the session, you will need to press star 1 on your telephone keypad. Please be advised that today's conference is being recorded. If you require any further assistance, please press star zero. I would now like to hand the conference over to your speaker today, Peter Salkowski, Vice President of Investor Relations. Sir, please go ahead.
spk06: Thank you, Catherine. Good afternoon, everyone. This is Peter Salkowski, Vice President of Investor Relations at Fortinet. I am pleased to welcome everyone to our call to discuss Fortinet's financial results for the second quarter of 2021, which we are hosting from inside of our new building. 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 the Investor Relations website. Ken will begin our call by providing a high-level perspective on our business. Keith will then review our financial and operating results for the second quarter before providing guidance for the third quarter and updating the full year. We will 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 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 your opinions only as of the date of this presentation. We undertake no obligation and specifically disclaim any obligation to update forward-looking statements. Also, all references to financial metrics that we make on today's call are non-GAAP unless stated otherwise. Our GAAP results and GAAP to non-GAAP reconciliations is located in our earnings press release and in the presentation that accompanies today's remarks, both of which are posted on the Investor Relations website. Lastly, all references to growth are on a year-over-year basis, unless noted otherwise. I will now turn the call over to Kenneth.
spk20: Thanks, Peter, and thank you to everyone for joining today's call to review our outstanding second quarter 2021 results. Buildings increased 35 percent to $961 million, driven by solid execution, and was the best it has been since 2015. Secure S demand accounted for 14 percent of second quarter buildings. Total revenue growth 30% to $801 million, with product revenue up 41%. Product revenue growth was the highest for nearly 10 years. Free cash flow was $395 million, a quarterly record level. With strong business momentum, we remain focused on growth. Today, we announced expansion of our 40 care and 40 guard security services, adding a new security service called 40 Trust, FortiTrust security services offer user-based licensing that follow the user across the organization's entire security platform. This enables organizations to easily manage and secure across all networks, endpoint, and cloud, which traditionally has been siloed. Initial service levels are being offered for Zero Trust network access and identity verification. We enhance the current FortiCare security services which cover all Fortinet security fabric product with three level of services to including 24 by 7 technical support and timely issue resolution. Additionally, FortiCon security service has been fine-tuned for different segment with added individual services for enterprise, bundles for commercial, and the packages for SMB. Leveraging industry-leading threat intelligence from FortiGuard Lab, FortiGuard Secure Service offers market-leading AI-enabled security capability that regularly adjusts protection across the Fortinet security fabric. Today, we announced a new FortiGuard 3500F, the industry's first high-performance next-generation firewall with integrated zero-trust network access and ransomware protection. powered by the 49MP7A6 SPU, the 3500F offers an average six times more performance than other competitive products based on our security computing. This makes the 3500F the best protection for high-speed internal network and data centers. We continue to see the momentum and adoption of SD-WAN Zero Trust Network Access, and cloud solutions among the world's largest service providers. In May, Fortinet was recognized as the winner of the Microsoft Security Customer Impact Award. Last week, Fortinet was named Google Cloud's 2020 Security Partner of the Year, recognized for innovative thinking, outstanding customer service, and best in class use of cloud products and services. Before turning the call over to Keith, I would like to thank our employee, customer, and partners worldwide for their continuous support and hard work.
spk19: Thank you, Ken. And to add to your comments, we should note that as in the prior quarter, buildings growth, product revenue growth, and total revenue growth all accelerated sequentially. In fact, all three growth rates were at five-year for net highs, and product revenue growth was at its highest in over nine years. Okay, let's start the more detailed Q2 discussion with revenue. Total revenue of $801 million was up 30%, driven by industry-leading product revenue growth of 41%. The product revenue growth was broad-based across geographies, FortiGate and non-FortiGate products, and across use cases, illustrating market acceptance and customer demand for our integrated single-platform security fabric strategy across customer infrastructures. Our financial strategy includes a rule of 40 target. We target the total of the revenue growth percentage and operating margin to be at least 40. In the second quarter, strong demand and execution drove this actual total to be a rule of 55. FortiGate product revenue growth was 40%. While we continue to see robust growth from our secure SD-WAN functionality, the majority of the growth was driven by FortiGate revenue from other capabilities, which are embedded in the FortiGate operating system. Non-FortiGate product revenue growth was over 40% for the second consecutive quarter and was driven by strong growth from our integrated security fabric products. One additional comment on our product revenue growth. Our product revenue growth was a reflection of our continued strong organic growth and not the result of a few large deals, drawing down backlog, nor an unusual number of delayed transactions from the prior quarter or pulled in from future periods. Service revenue of $503 million was up 24%. Support and related services revenue of $230 million was up 26%, while security subscription services revenue of $273 million was up 23%. Moving to the mix of FortiGate and non-FortiGate platform revenue, FortiGate product and services revenue increased 26%, driven by very strong demand for both branch and high-end FortiGate products. High-end products included 10 NP7-powered FortiGate models, representing approximately 25% of high-end FortiGate shipments. Our ASIC-driven FortiGates give customers 5 to 10 times more computing power than firewalls running on common CPUs. The advanced computing power creates additional speed and capacity to continue to add functionality to our operating system, further driving our price for performance advantage. The combination of the ASIC advantage and the common operating system across products can enable vendor consolidation, lowering total cost of ownership, and increasing automation. Non-FortiGate product and services revenue grew 39% and accounted for approximately 30% of total revenue, up over two percentage points. The integrated security fabric consists of a complete range. Could you close that door? A bit of a rehearsal for our hands meeting later on today, folks, so you've got an inside scoop on what Patrice is going to say. Let me start again, if I may. Non-FortiGate product and services revenue grew 39% and accounted for approximately 30% of total revenue, up over two percentage points. The integrated security fabric consists of 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. Together, they provide a range of security solutions and form factors, enabling integrated protection for the hybrid environments and the expanding digital attack surface from network data centers to endpoints to the cloud. Let's turn to revenue by geo. As summarized on slide 5, revenue in EMEA increased 34%, The Americas revenue increased 29%, and APAC posted revenue growth of 24%. Product revenue growth for both the Americas and EMEA regions was over 40%. Moving to billings. Second quarter billings were $961 million, up 35%. We saw strong growth in both the FortiGate and non-FortiGate segments of the security fabric platform. The FortiGate segment delivered billings growth of over 30%, accounting for 71% of total billings. As shown on slide 6, branch and high-end FortiGates posted very strong billings growth. The non-FortiGate segment accounted for over 29% of total billings and delivered billings growth of over 45%, driving a two-point mix shift to non-FortiGate products and services. Given the continued strong performance, we believe our non-FortiGate platform is on a pace to be a $1 billion business this year. Secure SD-WAN billings represented 14% of total billings, and it's a key functionality for an integrated SASE solution. In terms of billings by geo, EMEA outperformed all geos, followed by the Americas and APAC. Europe had a very good quarter, and growth in the Americas was driven by the United States, which was up sequentially by more than 30 percentage points. Latin America continued to recover from the pandemic-induced slowdown, posting buildings growth in the mid-20s for the second consecutive quarter. The average contract term was approximately 28 months, up two months from the second quarter of 2020, and one month from the first quarter of 2021. Deals over $1 million increased from 59 to 79, and the pipeline for deals over $1 million continues to look good for the remainder of the year. Secure SD-WAN deals over $1 million increased from 13 to 19, Moving to worldwide buildings by industry verticals. Buildings by vertical illustrate the diversification in our business model, and importantly, suggest the current threat landscape is driving security investments in industries that may have historically shown lower investment levels. For example, the verticals that have historically not been in our top five combined for buildings growth of over 75%. Service providers accounted for 14% of total billings and were up 25%. Moving back to the income statement, product revenue growth of 41% drove a three-point shift in the product and services revenue mix, and along with it, a gross margin decrease of 160 basis points to 77.5%. Product gross margin improved 70 basis points to 61.7. Services gross margin decreased 160 basis points to 86.9. with data center investments in FX accounting for about 100 basis points of the impact. Operating margin of 25.4% was at the top end of the guidance range, despite a 350 basis point headwind from the gross margin decline, a weaker U.S. dollar, and increased travel and marketing event costs. We ended the quarter with a total headcount of 9,043, an increase of 17%. Moving to the statement of Statement of cash flow summarized on slide seven and eight. Pre-cash flow for the second quarter came in at a quarterly record of 395 million, benefiting from strong revenue growth, good month one linearity, and lower capital expenditures. In the quarter, we repurchased approximately 455,000 shares of common stock for a total cost of $92 million and an average share price of approximately $201. The remaining share repurchase authorization at the end of the second quarter was $921 million, with the authorization set to expire at the end of February 2022. We ended the first half of the year with total cash and investments of $3.4 billion, an increase of $1.7 billion. The increase includes the proceeds from our $1 billion investment-grade debt issuance during the first quarter of 2021. DSOs returned to pre-pandemic levels, decreasing seven days year over year and 15 days quarter over quarter, to 66 days. Inventory returns increased to 2.7 times from 2.2 times, reflecting strong product sales in the quarter. Capital expenditures for the quarter were $24 million, and we have started to move into the new Sunnyvale building. We estimate third quarter capital expenditures to be between $65 and $75 million, which includes a $30 million payment for the new campus building. We estimate 2021 capital expenditures to be between $175 and $200 million. With the acceleration of the growth and a little more understanding of the post-pandemic work patterns, we're turning our attention to reviewing our facility's footprint and the needed office and warehouse capacity in the U.S. and Canada. As we work through this process, it is possible that our estimated capital expenditures over the next few quarters will increase as we prepare for the next phase of our growth. Looking forward, our goal remains to balance growth and profitability. And given the growth opportunities that we believe lie ahead, We continue to expect to tilt our bias within this framework more towards growth for at least the next several quarters. The opportunities we see are supported by a strong pipeline, increased sales effectiveness, the growing success of the single integrated security platform strategy and the convergence of security and networking, the response to the current threat environment, and our development efforts, which include continuing to invest in our ASIC advantage, which enables a shared operating system across the security fabric platform, drives our price for performance advantage, and creates the capacity to add features and functions while maintaining price points. 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. For the third quarter, we expect buildings in the range of $940 million to $960 million, revenue in the range of $800 million to $815 million, Non-GAAP gross margin of 77.5 to 78.5 percent. Non-GAAP operating margin of 24.5 to 25.5 percent, which includes an estimated 200 basis point headwind from foreign exchange and increased travel and marketing costs. Non-GAAP earnings per share of 90 to 95 cents, which assumes a share count of between 169 and 171 million. We expect a non-GAAP tax rate of 21 percent. With that, we are raising our 2021 guidance and expect billings in the range of $3,870,000 to $3,920,000, which in the midpoint represents growth of approximately 26 percent. Revenue in the range of $3,210,000 to $3,250,000, which in the midpoint represents growth of approximately 24.5 percent. Total service revenue in the range of $2,045,000 to $2,075,000 which represents growth of approximately 23% and implies full-year product revenue growth of approximately 28%. Non-GAAP growth margin is 77% to 79%. Non-GAAP operating margins are 25% to 27%, which includes an estimated 200 basis point headwinds from foreign exchange and increased travel and marketing costs. Non-GAAP earnings per share are $3.75 to $3.90, which assumes a share count of between $168 and $170 million. We expect our non-GAAP tax rate to be 21%. We expect cash taxes to be approximately $90 million. Along with Ken, I'd like to thank our partners, customers, and the 4Net team for all their hard work, execution, and outstanding success in the first half of 2021. I'll now hand the call back over to Peter for the Q&A session.
spk06: Hey, Keith, operator Catherine, we're ready to open the call for questions, please.
spk15: Sure. As a reminder, to ask a question, you will need to press star 1 on your telephone keypad. To withdraw your questions, press the pound key. Please stand by while we compile the Q&A roster. And our first question is from Brian Esick of Goldman Sachs. Sir, please go ahead.
spk16: Great. Thank you for taking the question, and guys, congratulations on the results. Really nice set of results this quarter. Maybe to start off, Ken, I know you've talked for years about not having exposure to firewall refresh cycles within your business. Could you maybe unpack a little bit the product revenue performance? Are you starting to see perhaps some exposure to the refresh cycles of others? Is this more, you know, rip and replace infrastructure upgrades or expansions? Maybe if you can maybe give us a little bit of an understanding of what's going on behind the product revenue growth this quarter.
spk20: Yes, thanks, Brian. Great question. I think the industry, whether during the pandemic or after the pandemic, probably seen some kind of a whole structure changing. It's no longer the traditional border kind of firewall will be enough. You have to expand into the one side, like secure SD-WAN, the 5G, and also internal, have to do like internal segmentation, replacing the switch with secure switch and the Wi-Fi to prevent all this kind of a kind of internal attack. So that's where, and also consolidation also going on, and they also need to have like a different pod infrastructure security integrate together to protect the whole attack, multi kind of attack surface protection there. So that's where we see it's a big change for the whole architecture of how to architect a new protection architecture to protect the whole infrastructure security there. So that's probably different than just refreshing traditional firewall, but it's the new expanded infrastructure need to have all protection there. So that's what we see, like the product we announced today, SuperHanded, has its local insight, the high-speed network environment to do all this kind of internal segmentation within data center protection and all these kinds of things. And then also we see very strong growth, whether the security brand and also the 5G growth. That's drive a lot of brand trial phase work on home solution there. That's where the union grew probably even much faster there. So we see that the whole infrastructure being changed, all the code security-driven networking starting to kind of more adopt by both enterprise and also all different kind of vertical.
spk16: Got it. That's super helpful. Maybe to follow up, service provider was slightly lower as a percentage of revenue this quarter. I understand that, you know, on the product revenue side and the high end, you saw a lot better growth, but should we think about That segment, you know, particularly to the extent that, you know, they might be selling through for SASE or you might be getting better traction with OPAIC. How should we think about growth of the service provider market? Is that still to come or is that a more stable kind of, you know, mid-20s grower segment for you?
spk20: I think it's in the ramp-up stage, still in the early stage of ramp-up. Compared to last quarter, probably like down about 15%. This quarter grew about 25%. So, like I mentioned, they're kind of a building for structure, whether for the 5G, SD-WAN, or SASE, which we have a different strategy. Our SASE strategy is actually quite a different, probably very different from other players. So, we have a dual strategy. We are probably the only one working with service provider to build in their SASE, and at the same time, like the service revenue, we kind of lower the margin that will be there. Also, you're matching some of our own infrastructure If some customer don't have a service provider or want to work with us directly, we also have our own kind of SASE solution there. We should also integrate with the 4DOS. Inside 4DOS, they have a built-in SASE, your trust network access, and some other part. It's also kind of a different than our competitor. And eventually, we also hope we can use ASIC or Celery to add additional computing power to our kind of own SASE solution there. So that's where we feel it's a long-term investment, but once we have it, we have a huge advantage compared to other competitors.
spk16: All right, that's helpful, Kala. Thank you very much, and congrats again.
spk20: Thank you.
spk15: Our next question, yes, sir. Our next question from Hamza Farlawala of Morgan Stanley. You may go ahead.
spk14: Hey, guys. Thank you for taking my question. I had a follow-up regarding the prior question on some of the drivers of product revenue growth. So, Ken, as your customers start coming back into the office or as we move into this more hybrid work environment, you talked a lot about these larger network transformation deals. I was wondering, what do you see the pipeline looking like for those larger deals heading into the back half and beyond? And do you think that You know, some of the things that we saw in the past 12 to 18 months is going to be an accelerant for those, you know, more larger infrastructure type deals.
spk20: Yeah, we see the pipeline very strong for the larger multiple product deal, which like approach, I mean, cover multiple part of infrastructure. And also, the product revenue growth, like 41%, is also very strong. We feel that our product is very different than the traditional or the small competitors that are using the CPU only. So we have the latest CPU for our industry, but also we developed ASIC in the last 21 years. Just like the product we announced today, the 3500F, based on our calculation, we call it secure computing region, basically for the same cost, what's the function performance compared to other competitors or industry average? So we have a six-time better performance, basically because the computing power advantage is huge for our own ASICs. So that's what's changing the landscape of the product, whether that was a security product or some other leveraged ASIC. This huge computing power gave us much more function and better performance that can easily replace a lot of our competitors. But at the same time, we do see the expansion total addressable market, whether it be from home or kind of a secure internal network inside the company, inside data center, which also drives a lot of high-end product growth. So the high-end product percentage also we see probably pretty high, maybe the highest in the last few quarters or even last few years.
spk14: Got it. That's helpful. And maybe just a follow-up question for Keith or Ken. Keith, you mentioned the The operating margin in the back half having about a 200 basis point impact from FX. I was just wondering, you know, just on your spending plans around hiring, what you're seeing there. It's obviously a very competitive market for talent these days, and I'm wondering if that's been factored at all into your guide.
spk19: Yeah, I think we obviously pay attention to our recruiting and to our attrition rates. I think the metric that we gave was that our overall headcount increased 17%. I would offer that sales headcount actually grew significantly more than that. So I think that we're in a bit of a sweet spot, and it kind of relates to what Ken was saying just a moment ago in terms of the success that we're having. I think you could read through to the high-end FortiGates as probably being data center deployments and probably taking advantage of some competitors that are going through a refresh cycle. At the same time, some of the branch forti-gates may be reflective of digital transformation. And I think that the audience of salespeople understand that and they see the opportunities there.
spk14: Thank you.
spk15: Answer our next question from Sterling Audie of J.P. Morgan. You may go ahead.
spk04: Yeah, thanks, guys. For my one question, I just wanted to dive into, Keith, in your prepared remarks, You made the comment that the majority of growth was driven by FortiGate revenue from other capabilities embedded in the operating system. I wondered if you could kind of peel back the onion there. What does that mean, and what capabilities were you referring to that were in particular demand in the quarter?
spk19: Yeah, I think that we've tried to make the point in the past that some people think about the firewall somewhat simplistically, and we probably track close to 12 to 15 different firewall use cases, whether you want to talk about microsegmentation, IPS, et cetera. All of those, the totality of those, the growth there contributed more, if you will, than SD-WAN. SD-WAN itself still obviously contributed very nicely at 14% of our total billings, which probably puts it close to about 35% or probably 55% growth. So I think there's a long list of things that a firewall is used for. and we were very pleased with the success that we saw throughout that suite of offerings.
spk20: Also, especially the 40.07, we have a building in Zero Trust Network Access and a building in SASE there. We see very strong interest in this area, both from the service provider, from enterprise, from work from home solution there.
spk04: Understood. Thank you.
spk20: Thank you.
spk15: And, sir, our next question from Rob Owens of Piper Sandler. You may go ahead.
spk10: Great. Thank you guys for taking my question and following the lead of Mr. Adi. I'd like to ask one question. Could you elaborate a little bit on your commentary around some of these non-traditional verticals that are starting to tick up meaningfully and spend? Is this more one time in nature or these verticals are just starting to wake up to some of the security issues that we're reading about in the media every day and to that, and maybe you could comment a little bit around your OT success and your strategy there. Thanks.
spk19: Rob, I think you did a very good job of laying all the dots to connect there. We're looking at industries or verticals such as manufacturing, transportation, energy, utilities, or what have you, and to see the dramatic growth that we saw in that segment of the business. We've historically talked about our top five, financial services, government, service provider, tech and retail, and they've been very consistent about that 65%, 66%. But we saw a significant shift this quarter to those others, and it was just the sheer growth that we saw in those others. And the point that you alluded to, OT. OT performed very, very strongly in the quarter, and I think that's consistent with what we saw with that vertical growth and those other verticals that I just mentioned.
spk10: Thank you very much.
spk15: Our next question from Marshall Ariel of Cohen and Company. You may go ahead.
spk12: Thank you. Also, single question on my end. When we look at the billing upside, revenue upside is printed, can you unpack for us the mix between you logos and the current installed base? Any qualitative color and discussion will be appreciated.
spk19: Yeah, this is Keith. New logos were very strong in the quarter, probably up about 50% year over year. And I've given numbers in the past that kind of suggest that 5,000 customers that we had in the quarter, obviously a very strong quarter is going to be north of that. First part of the response. Second part of the response, you would not normally expect to see that the new customers in the initial quarter would be significant contributors to revenue, but rather contributors to revenue growth over a longer period of time. But there was a very strong performance from the new logo segment in terms of customers that signed up with us in the quarter. Thank you.
spk15: Our next question from Sakit Kaya of Barclays. Please go ahead.
spk05: Okay, great. Hey, thanks for taking my question here. Ken, maybe for you, you touched on this a little bit in your prepared remarks, but Can you just talk a little bit about the new pricing options that you announced recently? You know, specifically, you know, do you feel like there's demand for that per user pricing for kind of access to the broader FortiCare and FortiGuard portfolio? And what was sort of some of the early feedback as you maybe tested those options?
spk20: We do see going forward, especially like all from home or remotely, The per user license, which can cover multiple devices, including the mobile or bring your own device to work from home. And also internal inside enterprise company there, like a cover multiple, like not just the 40K that they go through to the Zero Trust network access, but also some other, like a web, a mail, some other application kind of a different part of infrastructure data center they need access. So that's per user license will make much easier for the user, for the customer to really use in all these security service in the multiple part of infrastructure, cover multiple part of there. So that's where we feel this is also very important add on top of the current FortiCare which cover all the part that we have and also the FortiGuard. cover the product need a real-time update on the subscription, all these kind of things there. So we feel this FortiTrust is probably the trend in the future, but still needs some time to ramp up. Especially we see the Zero Trust Network Access starting to have a pretty quick growth opportunity with which the FortiCade already have all this built in. And also the identity, how to like kind of make sure the identity across multiple infrastructure can easily kind of manage by the user. We feel all these two surveys also kind of stand out as very important. It still needs some time to ramp up, but we do see there's a huge interest and demand from the customer. That's also the reason we launched this U40 Trust Service.
spk05: Got it. Thank you.
spk20: Thank you.
spk15: Our next question, sir, from Michael Torres of KeyBank. You may go ahead.
spk13: Hey, everybody. Huge quarter, of course. I think we're both key fans for Ken. A lot of people have been circling around and trying to understand the strength and the upside. But I guess I'd like to just try to compare where the demand was last year during 2020 to where it is this year and why it seems so much stronger. Has there been a shift, say, from remote access focus to more breach or What has changed both qualitatively and quantitatively that we're seeing this acceleration?
spk20: Last year, they probably more like in the rush supporting whatever can make it working remotely. But this year, they definitely see the infrastructure need to be upgraded, need to be changed to most support in this long term. So that's where you see a lot of new infrastructure design and how to support and not just work remotely, but also secure the whole infrastructure, different part of infrastructure from the WAN access to the internal segmentation and also even the 5G or internal Wi-Fi. So there's a lot of new secure architecture covering multiple parts of a product. It's a very strong interest. And also Keith mentioned the OT, some injuries because of whether the 5G IoT, also that part also rather strong.
spk19: Yeah, Michael, I think I agree with Ken completely. And maybe just add, if you think back about Q2 2020 specifically, at least for us, you know, it was a quarter that was characterized probably by a lot of software. We did very well with our software in the second quarter last year. But on the flip side, you know, anything that required somebody to be on-premise in a data center or, taking on a large deployment or phase deployment or something like that. Q2 of last year, there really wasn't much of that. Obviously, today, I think it's, you know, a year later, it's a very, very different environment in that regard. And I do think you're also seeing, you know, the threat environment and things like the OT part of the business do very, very well.
spk13: Great. Thanks, Kenneth.
spk15: Our next question from Jonathan Hu of William Mayer. You may ask your question.
spk01: Good afternoon. I just wanted to understand if you're running into any issues around the supply chain or potential chipset shortages, and does this, you know, lead to any potential impact to your order cadences at all?
spk19: Jonathan, I'd love to say that we're completely immune to chip shortages and such, but I can't say that. You know, I do think that as we talked about last quarter, the fact that our inventory turns, you know, hover around two, you know, are suggested that we have six months of inventory on hand. We do, and some of the chip manufacturers are pretty focused on a 52-week lead time. I think I feel very, very good about how the manufacturing and operations team executed in the second quarter and how they're going about things for the third quarter and for the rest of this year. I would offer that as part of the forecasting process and the guidance-setting process, that has become a more significant input, if you will, into that process and making sure that we've accounted for it And in terms of our SMS of any challenges that we may have as we move through the rest of the year. Thank you.
spk15: Our next question from Ben Bolin of Cleveland Research. Sir, you may go ahead.
spk07: Good afternoon, everyone. Thanks for taking the question. Ken, historically, when there are periods like this where you see accelerated purchase behavior a little bit of a run-on supply, if you will. Inevitably, there's a bit of a digestion period after the fact as customers learn how to deploy and consume what they just purchased. Could you talk a little bit about how Fabric and the broader organization, either in sales or the channel, is addressing or thinking about that potential risk into the future?
spk20: Yeah, we definitely see more and more customers see the benefit of the fabric, FUNA fabric, which cover multiple products and integrate ultimately together. So that's also making the non-40-day grow faster than the 40-day and will be over a billion dollars. We think it will be over a billion dollars this year. So when customers buy these multiple products, most of them are already like whether they are already customer or already test some of the pod. And they just keep expanding beyond what's the initial purchase there. So we do see the interest guys stronger and stronger and the non-40 gate also keeping much faster than the 40 gate, which keeping expanding from whatever the current installation base within the big enterprise. That's also the Gartner forecast. You see the integration, the consolidation starting kind of more and more important for these big enterprises because to manage multiple products from different vendors is a much higher cost compared to the platform approach, which can multiple products cover different infrastructure, also integrate all of them together, which is the foot in the fabric approach that we have.
spk19: To kind of build on Ken's comment, I think that is the business strategy, right? If we look at our install base of customers and see how their adoption progresses in terms of the number of fabric products that they add over what period of time, we would certainly expect that to continue on. And then if you look in the current quarter, the new customers that we added, those are largely buying firewalls, if you will, and maybe one or two things, if you will, from the fabric suite. But as We would expect them, because I understand they have to digest and install the firewalls, but as they get to know and understand our product and our integration strategy more and more, that we'll have the opportunity to come back in and sell them additional products and services as we go forward.
spk00: Thank you.
spk15: And our next question from Gray Powell of BTIG. You may now ask your question.
spk11: Okay, great. Thanks. Yeah, so I'd like to stick with the topic of non-forti-gates and Fabric and Cloud and just sort of the strength that you've been seeing there. Within Fabric and Cloud, what are like the biggest product components that have the most momentum? And then how should we think about just the sustainability of that demand longer term?
spk20: The number for today we have almost 30 product most of all developing internally and it's a super we have not give up any individual product because up and down quarterly and also pretty much all contribute kind of to the growth we don't see any any one or two too much kind of a often compared with others. So that's probably maybe sometime later we can get certain things out. But at this stage, we do see it's also dependent on the customer environment, dependent on the sales supporting. Like some of them have an email working with FortiGate. Some it's a website. Some it's Endpoint. Some it's a network access control or some kind of sandboxing or cloud approach. It's quite a quite a wide coverage of all kind of even cover all these like a 2030 product. So that's where it's very difficult to break out and then try to see the trend. But we do see the common message really consolidate, integrate, automate approach definitely has a huge benefit compared to our separate product come from different vendor.
spk11: Got it. That's really helpful. Thank you very much and congratulations on the great results.
spk20: Thank you.
spk15: And everyone, as a reminder, to ask a question, you will need to press star 1 on your telephone keypad. That is, again, star 1 on your telephone keypad. And our next question, from Adam Tindall of Raymond James, you may now ask your question.
spk08: Okay, thank you. I wanted to ask a strategic question to Ken. You had record quarterly free cash flow, so Keith's doing a poor job at managing that more efficient balance sheet he talked about at the analyst day. But all joking aside, Ken, you've got significant liquidity available both on the balance sheet and can imagine lenders beating down your door. So if you could double-click on the key tech areas that you would consider to enhance the value proposition, I would just imagine that SASE is accelerating or the SD-WAN leader. For example, some of those secure web gateway players in the private markets are more mature and would that be an area of consideration or any other key areas that you would consider enhancing the value proposition inorganically? Thank you.
spk20: Yeah, we're definitely keeping close to watching all the changes in the industry and also new technology, all these things. But also we want to keep the innovation, not the culture we had in the last 21 years and also keep the organic growth very strong. I probably leave the cash level investment strategy to Keith to cover that.
spk19: Yeah, I think for us, I mean, we look at our R&D spending as a source of investment, not a traditional capital allocation, but we have historically been a buy versus, pardon me, a build versus buy company, and that is to, we feel strongly about the importance of having the platform to be integrated. You do see us doing tuck-in acquisitions. Sometimes they take a little bit longer to bring to market, perhaps because the technologies are things that we want to work with a little bit more before we bring them out. So I don't think that's a surprise. I don't know that that precludes us from doing something larger in the future, but we'll look at those opportunities as they come up. The continuing focus will be finding the opportunities to rebalance the balance sheet with a little bit of the deploying some of the cash that we raised with that offering, perhaps to repurchase some shared buyback, if you will. And at the same time, also, as we look out for the next three to five years and we anticipate continued growth, you know, perhaps a little more investment, if you will, in our facilities footprint.
spk08: That's helpful. Thank you.
spk15: Our next question from Irving Liu of Ivercore ISI. Sir, you may go ahead.
spk17: Hi, thanks for letting me on, and I would also like to add my congratulations on the great quarter. I had a question on SD-WAN. I was wondering if you can perhaps unpack some of the drivers behind the continued momentum here, whether the current hybrid work environment has been a contributor behind this strength, and can you help us understand what workers gradually returning to offices means for you?
spk20: Yeah, Evan, good question. The SD-1, we still see very strong demand and also huge potential. The approach we have is integrated with security from our beginning and leverage the 40K has a huge computing power part of 40OS 40K. We see a huge advantage compared to some other competitors, whether using the universal CPU or some other approach, which is difficult at any function because the computing power limitations for the low-cost CPU. So that's where we do believe we will be the leader, the number one leader in the IC1 space. If not now, it definitely will be soon. And IC1 offers a huge advantage, like the readability, the cost saving compared to the traditional networking protocol MPLS or some other part. And also a lot of service providers are also starting to focus on the IC1 or 5G, some other part. which also kind of fit in our kind of long-term bigger picture we call secure-driven networking, which will be, compared to today, all the networking just through the connection and the speed. And then the secure-driven networking also need to look at an application, the content, the device behind, the user behind, and even different kind of location there. So that's what we see. How does that kind of security function add on top of networking has huge potential. which SD-WAN, the secure SD-WAN, also just one part of it, but also the secure 5G and also internal secure switching, secure Wi-Fi, we do see a lot of potential to keeping using security to cover the whole infrastructure.
spk17: Got it. Thank you. Thank you.
spk15: Our next question from Taz. of Guggenheim Partners. Jerry, you may go ahead.
spk03: Hey, guys. Thanks for taking my question. I have a question on the attach of support and subscription to your product this quarter because it looks like you had strong momentum in product. You had strong billing momentum also, but it looks like the upside in product didn't lead to maybe sort of similar upside in billing. Was there a difference in product mix which led to a difference in attach rate between subscription and support this quarter?
spk19: I think we track our attach rates and our renewal rates, if you will, within those bands you see in the analyst data of plus or minus 2%. And I think that we were comfortably inside those bands, so there was nothing unusual in that regard. I think that the services billings in total were probably, I have to go back and check, the best quarter that we've had in four years. So I think we feel good about both the services and the product performance in the quarter.
spk03: And just one follow-up. You gave us the mix of billings between FortiGate and non-FortiGate. Is that the same kind of mix you have in the product line also? The 70-30 roughly, is that the mix of non-FortiGate and FortiGate in the product line, or is that mix different for product?
spk19: Yeah, I don't have that number in front of me, but I don't have a reason. I don't recall them being significantly different when we looked at them, and I'm trying to recall what we made in the script just a moment ago in terms of product revenue. Yeah, I think we've offered FortiGate product revenue growth in the script as well as non-FortiGate product growth. FortiGate was 40% and non-FortiGate was over 40%.
spk06: Those are growth rates. We haven't given a breakdown by mix for the two, per product. We haven't given FortiGate product and non-FortiGate product as a mix. We haven't given that.
spk03: Got it. Cool. Very helpful. Thanks, guys.
spk15: Our next question from Patrick Colville of Deutsche Bank. You may go ahead.
spk18: Hey, thank you so much for taking my question. I mean, 41% product growth is extremely impressive. I guess, you know, the questions we're fielding from investors around the cyclicality or, I guess, whether it's secular growth. And so could you just help us understand, you know, were there one-time benefits or you know, cause of recent hacks or cause in recent events or post coronavirus that led to this kind of very strong number, or are you feeling that, you know, the firewall market, there are some secular dynamics that we should be aware of?
spk20: Uh, yeah, we do see the lot of products that didn't go into the, uh, not of a new part of a infrastructure or kind of a new area. And that's also, like Keith mentioned, beside the top five vertical, we do see the other vertical grow faster, much faster than the top five verticals, the government service provider, finance service, education, high tech, something like that. But also, like, among infrastructure, we do see, like, whether deployed on the one side, on the whatever, the smart city or some other kind of internal infrastructure within data center or even work from home, there's quite a broad kind of like a buying pattern compared to before. And that's also, we do believe, eventually will drive the additional service because once the product revenue go up and the service revenue will come in later. and also plus the introduction of the new FortiTrust service, we feel it's also an additional layer of a potential trust service for the future. It's definitely not, definitely the secular, like I mentioned earlier, we feel it's a change of the security infrastructure. It's not kind of refreshed or replaced the traditional firewall, which also from time to time needs to be upgraded. because now we're getting faster and faster, but also expanding into the new infrastructure part and also kind of a new area. We can see all kind of grow faster than the traditional microfinance surveys or some other part.
spk19: Yeah, to Dr. Kent's comments, I think it was a quarter, and it has been for a while now, that we just saw a lot of tailwinds. You know, the tailwinds included whether it was SD-WAN or OT as an example. The refresh opportunity, if you will, is really an opportunity for us to, we view as an opportunity to displace the incumbents. As compared to Fortinet that has 500,000 customers and 70 different firewall models, and even today we announced a new firewall in our press release. It's not as if historically you've seen blips with us in terms of spikes from refresh. But on the flip side, some of the competitors, the legacy players, have a shorter list of customers and a shorter list of products and maybe are not doing as well in Gardner Magic Quadrants as we are. So we view that as an opportunity. I do think that other tailwinds that came into the quarter, we talked about the verticals. Ken mentioned it again. And also when I look at our customer sizes, whether SMB to all the way to the Global 2000 did very, very well. I think one thing that stood out for us was the mid-enterprise or the commercial part of the business. That came on very, very strong in the quarter as well. So I think there was a long list of tailwinds for us that works in our favor on that product revenue growth number.
spk20: Also, we feel with the introduction of the new product, the computing power advantage comes from ASIC. It's bigger and bigger compared to other competitors, which not only help in replacing some of their installation base, but also expanding the new area of the internal network in a high-speed environment, but also has a much more function beyond the traditional network security, like for our VPN. Like we mentioned, whether from the access or some other, like a SASE or other part, like SD-WAN and the 5G security, which none of the traditional firewall has. And that's also what drives the additional, like, sales on the product and also the future service. which is not refreshed compared to the traditional firewall, which they don't have that function or don't have the computing power to keep an additional function of the current performance demanding. So that's where we feel the strategy we have leveraged ASIC computing power advantage and give us additional function and additional performance, much lower cost, and starting working quite well.
spk18: Great. Thank you so much.
spk20: Thank you.
spk15: Our next question from Paul Liani of Bank of America. Let me go ahead.
spk09: Hey, great. Thank you. I want to talk about gross margin. If I'm correct, and if I'm not, it's not going to be the first time, but if I'm correct, your gross margin had gone down about 140 bps sequentially, and I also checked it versus consensus. It's lower 100 BIPs lower than consensus this quarter, next quarter, and 200 BIPs below consensus for the year for the guidance. So do I have a mistake in my calculation, or if not, can you elaborate on gross margin? Why is it lower sequentially in the guidance?
spk19: Yeah, I think what you're seeing, Tal, is the mix shift, right, the product mix shift versus the services mix shift. You can do some pretty simple math in the second quarter and you can get to, you know, when you have 41% product revenue growth at 61, 62% gross margin versus the services that's fairly constant at 23% and 88% gross margin. You know, that 25% swing in gross margin, when you take that back and you look at a 20 point or 25 point over performance in product, it works out to be just about one point, maybe just a little bit north of one point on the gross margin line.
spk20: Also, you can look on the product growth margin. We actually improved year over year. Even the cost kind of increased, but we do improve the product growth margin. And also, we do believe with the product growth 41%, we can drive a lot of future growth in the service. That's also the reason we enhanced the 40 care and the 40 guard and at 40 trust. which we do believe will keep making the future so that the service will grow faster going forward.
spk09: Is there any change in the pricing environment?
spk19: There's no change in the discounting. Discounting for the quarter was neutral for us, if you will. We have taken certain steps as we look forward to some of the changes in the cost structure that we're seeing from our suppliers. and we've taken certain steps in terms of our own pricing that have not actually hit yet, but they will hit in time for when we actually see those costs in our income statement.
spk09: Can you elaborate on the last point? What does it mean? So do you expect the margins to decline, or do you expect to increase prices in anticipation?
spk19: I do not expect margins to decline, no, beyond what will happen with the mix shift, if you will, between products and services. To the extent we continue to over-exit, to overperform in the product line the way we just did, you know, it's going to put pressure on the gross margin line. But keep in mind, you know, the operating margin came in right at the high end of the range. So I think we successfully managed that. And it's certainly very consistent with what we foreshadowed earlier in the year where we said within our framework, this was a year in which we would tilt towards growth. We obviously did that putting up 35% buildings growth and 41% product growth and at the same time delivering 25% operating margin plus, right?
spk20: We also did more investment on the infrastructure, which kind of making the service revenue gross margin lower a little bit, but also helping the future additional service come in.
spk09: Great.
spk20: Thank you.
spk15: Our next question from Itai Kitaron of Oppenheimer. You may ask your question.
spk02: Thanks, and great results as well, guys. Ken, I was hoping you gave a lot of great color on the backdrop and what you're doing and how you're executing well in the field. But maybe you can tie it up also with the competition discussion. Maybe you can kind of help us understand what you're seeing from your competitors right now and Who do you see is most vulnerable for share loss? It's clear that you're going to continue to gain share in this marketplace for the foreseeable future, but who do you see as the more vulnerable vendors here that are likely to cede to you and others that bring to the table what you can bring to the table?
spk20: Go ahead. All the competitors are good. But we just have some long-term strategies investment, which give us more advantage, whether from the ASIC chip, which we started to do 21 years ago, or starting to do in our other part of fabric products, which integrate ultimately from day one. compared to our competitor, MoCom for acquisition, make it a lot difficult to do the integration and automation and maintain the organic growth there. But on the other side, we do see there's certain market shift changing. We also want to take the time, like our SaaS strategy, we have a property-only vendor working with a service provider to feed their SaaS need, long-term, build product for them, at the same time building some infrastructure, some other things, integrate, within the 40K, 40 OS, as the single OS or product can cover both the SASE, their customer access, or some other part, such as FD1 security, making the product kind of more easy for customer to deploy and fit in the big environment, fast environment, much, much better. So that's why we continue to have this kind of a lot of long-term strategy, and we do see that there. will give us a long-term benefit going forward.
spk02: Very good. I tried. Thanks, guys. Thank you.
spk15: Speakers, that would be our last question for this call. And I'll turn it back over to Peter Salkowski. You may go ahead.
spk06: Thank you, Catherine. I'd like to thank everyone for joining the call today. Fortinet will be attending the following virtual investor conferences during the third quarter. We're doing the Oppenheimer Conference on August 10th. and KeyBank on August 11th. Events with presentations will be webcast, and those webcast links are going to be up on our website. Actually, they're already up on our website as of now. If you have any questions following this call, please feel free to reach out to me. As with that, have a great day and take care, everyone.
spk15: This concludes today's conference call. Thank you all for joining. You may now disconnect.
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