Fortinet, Inc.

Q2 2022 Earnings Conference Call

8/3/2022

spk13: Good day, and thank you for standing by. Welcome to the Fortinet Second Quarter Earnings Call. At this time, all participants are in a listen-only mode. After the speaker's presentation, there will be a question and answer session. To ask a question during the session, you will need to press star 1-1 on your telephone. You will then hear an automated message advising you that your hand is raised. Please be advised that today's conference call is being recorded. I would now like to hand the conference over to your speaker today, Peter Solinsky. Please go ahead.
spk08: Thank you, Hope. 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 second quarter of 2022. Speakers on today's call are Ken Zee, Fortinet's Founders Chairman and CEO, and Keith Jensen, our Chief Financial Officer. This is a live call that will be available for replay via webcast on our Investor Relations website. Ken will begin our call today by providing a high-level perspective on our business. Keith will then review our financial operating results for the second quarter or providing guidance for the third quarter, updating the full year. We'll then open the call for questions. During the Q&A, we ask that you please limit yourself to one question and one follow-up question to allow for others to participate. Before we begin, I'd like to remind everyone that on today's call, we'll be making forward-looking statements, and these forward-looking statements are subject to risks and uncertainties, which could cause actual results to differ materially from those projected. Please refer to our SEC filings, in particular the risk factors in our most recent Form 10-K and Form 10-Q, for more information. All forward-looking statements reflect our opinions only as of the date of this presentation and we undertake no obligation and specifically disclaim any obligation to update forward-looking statements. Also, all references to financial metrics that we make on today's call are non-GAAP unless stated otherwise. Our GAAP results and GAAP to non-GAAP reconciliations are located in the earnings press release and in the presentation and accompanying today's remarks, both of which are posted on the Investor Relations website. Ken and Keith's prepared remarks today for the earnings call will be posted on the quarterly earnings section of our Investor Relations website immediately following today's call. Lastly, all references are on a year-over-year basis unless noted otherwise. I'll now turn the call over to Ken.
spk07: Thanks, Peter. Thank you to everyone for joining today's call to review our outstanding second quarter 2022 result. Total building increased 36%, the sixth consecutive quarter of at least 35% year-over-year building growth. Revenue growth 29%, driven by 34% of product revenue growth. SD-WAN and OT bulking growth over 60% and 75%, which together accounted for 25% of a total second quarter bulking. Our better than expected performance demonstrate the strong demand for our cybersecurity innovation. Fortinet is at the forefront of networking and security convergence. enabling our customer to reduce complexity while securing and connecting hybrid and remote user to advance security with superior performance. Today, we announce the FortiGate 4800F, our latest innovation in converged network security. The 4800F is the world's fastest compact firewall for hyperscale data center and 5G network. Powered by a 400 MP7 SPU, the 4800F delivers security computing of an average 5 to 10 times better performance than competitive solutions across the six most common and important functions. A leader in the Garmin Magic Quadrant for one-edge infrastructure, Fortinet continues to take market share for Secure SD-WAN. Our integrated Secure SD-WAN solution, powered by Fortinet SPU SoC 4, deliver huge performance, security, and efficiency over traditional offerings. In addition to convergence, consolidation of vendor and product functionality is another major trend, particularly in network security. In a recent CISO survey, Gartner found the percentage of companies surveyed who want a fewer security provider increased to 75% from only 29% in 2020. With over 30 product lines built mostly by our in-house strong engineering and development innovation, Fortinet has benefited from this consolidation with our security fabric mesh offering. The Fortinet security mesh platform delivers unparalleled protection with a broad, integrated, and automated protection across multiple edges, from endpoint to data center and hybrid cloud environment. These two major trends, convergence and consolidation, position Fortinet well for long-term growth. Before turning the call over to Keith, I would like to thank our employees, customers, partners, and suppliers worldwide for their continued support and hard work that are contributing to Fortinet's strong growth.
spk19: Thank you, Ken, and good afternoon, everyone. Let's start the more detailed quarterly discussion. Second quarter results were solid and broad-based, across geographies, customer sizes, industries, and use cases, driving market share gains and demonstrating the strong growth from our three key growth drivers. First, an elevated threat environment. Second, the convergence of security and networking. And third, the consolidation of security products across our platform offerings. Total revenue of $1.3 billion was up 29%. passing the $1 billion milestone in quarterly revenue for the first time in our history. Total product revenue growth was up 34%. Core platform and platform extension product revenue growth was up 35% and 33%, respectively. We continue to see robust product revenue growth from a wide range of security use cases, including secure SD-WAN and operational technology, or OT. Total service revenue growth increased sequentially to 25%, resulting in service revenue of $629 million. Support and related service revenue was up 26% to $289 million, while security subscription service revenue was up 25%, or two points sequentially, to $340 million. Service billings, defined as total billings minus product revenue, were up 36%. The year-over-year growth rate for short-term deferred revenue has increased for six quarters in a row, from just under 21% in Q4 of 2020 to just over 31% in Q2 of 2022, the highest short-term deferred revenue growth rate in over six years. The accelerating growth rate for service billings and short-term deferred revenue reflect the earlier pricing actions that quickly appeared in product revenue and they're now beginning to appear in service revenue. The pricing benefit more than offset various service revenue headwinds, including suspending services in Russia, an increase in the average number of days between when a customer purchases and subsequently activates a security service contract, and the impact of contract manufacturers delaying deliveries to later in the quarter, which limits our service revenue on new sales recognized in the quarter. With the growth in pricing benefits more than offsetting these headwinds, we expect service revenue growth will continue to accelerate through 2022 and into next year. To summarize on slide six, total revenue in the Americas increased 23 percent, EMEA revenue increased 28 percent, and APAC posted revenue growth of 42 percent. Despite macro conditions that may be more readily impacting other industries, our pipeline growth remains strong. In particular, EMEA's pipeline growth indicates continued strength in our European business. Moving to a summary of our success with large enterprises, large enterprises continue to favor Fortinet's leading cost for performance advantage and are increasingly more appreciative of our integrated platform. The platform strategy allows customers to converge networking functionality with security capabilities and consolidate multiple point products. Our success with large enterprise customers includes global 2000 bookings growth of over 65% year-over-year and on a rolling four-quarter basis. Large enterprise booking growth of over 55% year-over-year and on a rolling four-quarter basis. And the number of deals over $1 million increased over 50% to 122 deals and the total billings value of these transactions Secure SD-WAN bookings grew over 60%, reflecting the convergence of networking and security, as well as a strong ROI for our customers. OT bookings were up over 75%, reflecting the continued response to the elevated threat environment. Shifting to billings, billings of $1.3 billion were up 36%, as Ken pointed out, representing the fifth consecutive quarter of billings growth in excess of 30%. I'll pause here to offer thoughts on product refresh cycles and their impact on our financial results. Specifically, we do not believe new product releases drive a near-term spike in our top-line growth. Rather, we believe the continual nature of our product releases drives long-term growth. For example, each new ASIC is included in a series of products released over several years. Our most recent ASIC chip the NP7 Security Processing Unit, was introduced in Q1 of 2020. Including the 4800F announced today, we have released nine high-end core platform products with the NP7 chip. And over the next several quarters, we will release several additional mid-range and high-end products with the NP7. And lastly, I would note that since the start of 2019, we have released over 23 new FortiGate models. While some of our competitors, which have much shorter product SKU lists, may have shown clear signs of product refresh cycles, our strong long-term performance illustrates an extended series of overlapping product maturity curves. Our platform billings were up 32% and accounted for 69% of total billings. As shown on slide seven, mid-range FortiGates posted very strong buildings growth, with the shift mixing five points in their favor, driven by demand, as well as supply availability. Platform extension billings were up 44% and accounted for 31% of total billings, a mid-shift of over 1.5 points. Average contract term was up one month year-over-year to 29 months, given by the strength from large enterprise customers and the 50% plus increase in the number of deals greater than $1 million. Worldwide, government buildings grabbed the largest share of the mix at 15%, and were up 45%. The top five verticals accounted for 60% of total buildings. Moving back to the income statement, total gross margin of 76.5% exceeded the midpoint of the guidance range by approximately 125 basis points, even as component labor and freight costs increased. And the year-over-year revenue mix shifted two points to product revenue, from higher margin service revenue. Product gross margin of 61.9% was up 20 basis points year over year, and 450 basis points sequentially, as pricing actions, product mix, and lower discounting offset higher component and other costs. Service gross margin of 85.9% was down 100 basis points due to increased costs associated with the expansion of our data center footprint, as well as labor costs and other costs. partially offset by benefits from FX, and some of the earlier pricing actions. Operating margin of 24.8% exceeded the midpoint of the guidance range by approximately 200 basis points. The year-over-year comparison saw the FX benefit offset by lower gross margins, increased travel and marketing costs, and other costs. Take count increased 27% to $11,508. Looking at the statement of cash flow summarized in slides 8 and 9, free cash flow was $284 million and was impacted by increases in DSO and cash taxes. DSO increased 14 days year-over-year and five days sequentially to 80 days due to the change in billing linearity driven by the timing of inventory deliveries from contract manufacturers. And new R&D capitalization rules increased second quarter cash taxes by $85 million to $110 million. Second half cash taxes of approximately $135 million are expected to be more evenly spread across the third and fourth quarters. For the first half of the year, our adjusted free cash flow margin, which excludes real estate spending, was 34%. Capital expenditures for the quarter were $39 million, including $21 million for real estate investments. We repurchased approximately 14.4 million shares of our common stock for a cost of $800 million. bringing the total year-to-date shares repurchased to $25.8 million for a total cost of $1.5 billion. The Board increased the share repurchase authorization by $1 billion. The remaining repurchase authorization is now $1 billion and $30 million. Inventory turns of 3.1 times were up a half turn year-over-year and down a half turn sequentially. Moving to bookings and backlog, as a reminder, Backlog is excluded from current quarter billings and revenue. Nonetheless, it is expected to provide increased visibility and a top-line tailwind in future quarters. Bookings are up 42% to $1.4 billion. Total backlog of $350 million is up $72 million sequentially and reflects very strong demand. Of the total backlog, networking equipment accounted for about 50%, while Florida Gates accounted for about 40%. We believe our backlog is very strong and sticky. Existing customers account for over 95% of total backlog, and no single end customer accounts for more than low single digits as a percentage of backlog. There are four deals in backlog, all from previously existing customers, with a remaining balance of over $2 million, but the together account for only 6% of total backlog. just 4% of ending Q1 backlog was canceled in Q2, and about half the deals in the backlog have been partially fulfilled, suggesting that double ordering is not a significant contributor to backlog. Consistent with the first quarter, we shipped approximately 60% of the prior quarter's backlog in the current quarter, as our operation and R&D teams did an excellent job navigating the tough supply chain environment. Nonetheless, we still expect supply chain constraints to be challenging throughout the remainder of the year. We're continuing to address the supply chain challenges in a number of ways, including by increasing inventory purchase commitments, redesigning products, qualifying additional suppliers, and certain pricing actions. We believe that even with these actions, demand will continue to outstrip supply. As a result, we expect backlog to continue to increase in 2022. And while the situation is very dynamic, we believe we will have access to sufficient inventory to meet our guidance. As we balance our pricing actions with the opportunity for continued market share gains, we have passed along most, but not all, cost increases. As such, we expect ongoing gross margin volatility from these increases, as well as shifts in our product mix related to inventory availability. Before reviewing our guidance, let's offer a few Fortinet-specific observations and areas you may have heard discussed elsewhere. In Q2, we noted certain larger transactions with increased or elongated negotiating cycles. Also, linearity pushed to later in the quarter and later in the last month of the quarter, mainly due to supplies constraints and their deliveries. Lastly, close rates were strong, and importantly, the aggregate value of deals that pushed were within our historical norms. Now I'd like to review our outlook for third quarter as summarized on slide 10, which is subject to the disclaimers regarding forward-looking information that Peter provided at the beginning of the call. For the third quarter, we anticipate our solid third quarter pipeline growth across deal types, sizes, and geographies to support the following. Bookings in the range of $1,455,000,000 to $1,485,000,000, which at midpoint represents bookings growth of 36%. Billings in the range of $1,385,000,000 to $1,415,000,000, which represents growth of 32%. Revenue in the range of $1,105,000,000 to $1,135,000,000, which represents growth of 29%. Non-GAAP gross margin of 75% to 76%. Non-GAAP operating margin of 25% to 26%. Non-GAAP earnings per share are $0.26 to $0.28, which assumes a share accounted between $810 and $820 million. We estimate third quarter capital expenditures between $105 and $115 million. We expect a non-GAAP tax rate of 17%. For the full year, we anticipate backlog that could approach or possibly exceed $500 million that will be offset by robust industry growth, pipeline strength, and market share gains fueling our growth and supporting the following. Buildings in the range of $5,560,000,000 to $5,640,000,000, which at the midpoint represents growth of 34%. Revenue in the range of $4,350,000,000 to $4,400,000,000, which represents growth of 31%. Total service revenue in the range of $2,620,000,000 to $2,670,000,000, which represents growth of 27%. It implies full-year product revenue growth of 38%. We expect non-GAAP gross margin of 75% to 76%, non-GAAP operating margin of 25% to 26%, non-GAAP earnings per share of $1.01 to $1.06, which assumes a share counted between $810 million and $820 million. We estimate full-year capital expenditures between $300 million and $330 million. We expect our non-GAAP tax rate to be 17%. We expect cash taxes for the year to be $265 million. As I mentioned earlier, cash taxes paid are higher in 2022 due to the new R&D capitalization rules in the U.S. Along with Ken, I'd like to thank our partners, customers, suppliers, and all members of the Fortinet team for all their hard work, execution, and success. I'll now hand the call back over to Peter to begin the Q&A session.
spk08: Thank you, Keith. As a reminder, during the Q&A session, we ask that you please limit yourself to one question and one follow-up question to allow others to participate. With that hope, please open the call for questions.
spk13: Thank you. At this time, we will conduct the question and answer session. As a reminder, to ask a question, you will need to press star 1 1 on your telephone and wait for your name to be announced. Please stand by while we compile the Q&A roster. Our first question comes from the line of Brian Essex with GS. Brian, your line is open.
spk11: Great. Great. Thank you. Good afternoon and thank you for taking the question. Congrats team on a nice set of results for the quarter. I was wondering if maybe, Keith, I certainly appreciate the commentary and granularity with the full year revenue guide. Can we maybe unpack some of the commentary on the services side and the lower, I guess, services revenue guide for the year? Maybe help us understand what's going on there and maybe pair that with your comments on delays and activations and how much insight you might have there that gets folks comfortable that there isn't pull forward. Thank you.
spk19: Yeah, I don't think, Brian, I don't think pull-forward really applies to the service revenue line, but maybe you're answering a couple of questions at once. I think to answer your question about service revenue, I think the biggest change from where we started the year is really about Russia. If you think about Russia, we talked at the very beginning, it's about 1.5% of our total revenue, and it applies to the service revenue line as well. Earlier in the year, we stopped recognizing revenue on existing contracts for services that provide in Russia in conjunction with our suspending of services. At that time, we did not anticipate it would be a full year event, but we are now. And if you kind of think through that, 1.5% of service revenue is Russia. So we've really backed out now for the full year, about $25 million of revenue related to Russia. That's the largest change there. I think the delay in registrations from when contracts are sold to when they're actually registered by customers, I think we pretty much got out of the quarter what we expected on that. That seems to be something in the current environment with inventory constraints that we're going to continue to see. I think the linearity part of it is a little bit new in that because the shipments occurred later in the quarter, there really wasn't the opportunity to get the service revenue from those Q2 shipments that we would normally get. And so I think those are really the parts to put together there. On the other side, I would probably point to, again, the short-term deferred revenue billings. and the number that we're putting up and the growth that you're seeing with that number, as well as service buildings itself. And I think the last comment on this, and we haven't talked about it before, is that the service contracts are really a use-it-or-lose-it contract, meaning it's not that they have the ability to cancel. They just have the ability to postpone the registration for a period of time, depending upon the geography, whether that's 90 days or one year or what have you. So eventually it comes to revenue, but the timing's been pushed out to that aspect. Got it.
spk11: That's really helpful. Thank you.
spk13: Thank you, Brian. Our next question comes from Fatima Bulani with Citibank.
spk12: Good afternoon. Thank you for taking my questions. Hey, Keith, this one's for you. Just with respect to some of the backlog, excuse me, detail and commentary that you shared, I want to hone in on the cancellation rates that you quantified for us. I believe you said it was about 4%. Can you give us a sense of what are some of the reasons behind the cancellation and what gives you confidence that that 4% isn't going to stretch or escalate into maybe mid to high single digits? Thank you.
spk19: Yeah, I think I would point to some of the factors that we've talked about before. I think that last quarter we talked about the cancellation rate being 5%. I think we're seeing it now at 4%. I think it's unlikely that existing customers, particularly those that have received partial shipments, are going to cancel. Also, I don't want to think that it's naive that as backlog gets older, and it's also why we provide that 60% of shipments from prior backlog number for the street to try and understand it. But if that number starts to tick up, obviously there's more risk in it. I think it's important to understand the guidance that we provide really isn't reflecting in any sort of shift in the backlog that we're going to shift a lot of things from backlog. So I think we're fairly prudent in that regard, and I think we're also comfortable with what I described as the stickiness of the backlog number.
spk09: Operator, next question. Okay. All right.
spk13: Thank you for that question, Fatima. Thank you. Our next question comes from Adam Borg with Stifel.
spk16: Hey, guys, and thanks so much for taking the questions. Maybe just on the macro, you talked a little bit about the demand environment and highlighted some delayed deals and elongated linearity. Maybe go a little bit deeper here and talk about what these customer conversations look like. Are these tied to any particular – verticals or geographies. You talked a little bit about large enterprise or larger deals. I'd love to hear about the midsize and smaller deals, too. Thanks.
spk07: Yes, Ken. So we do see a lot of customers, especially enterprise, deciding to design some new infrastructure to support in the work from anywhere and also expand security beyond the traditional network security and into whether like internal segmentation to prevent all this ransomware attack, or go to work from home, and at the same time have multiple security products need to be automated, integrated together, so we call the consolidation, both on the product side and on the vendor side. I feel this kind of trend will be lost for the next few years, will be pretty long-term change, and at the same time, Keith also mentioned elevated security threat environment, also another drive. So that's where we see the trend will keep going for the next few years. If you look at the building number compared to two years ago, I mentioned in my script is that we have over 35% of building increase in the last five quarter compared to two years ago, Q1 2020 is only about 14%. So we do see the change in acceleration and also the convergent consolidation going on in the whole space right now will be pretty much drive the mountain growth.
spk13: Our next question comes from Sakit Khalia with Barclays.
spk05: Okay, great. Hey, guys, thanks for taking my question here. Keith, maybe for you, I'd love to talk a little bit about bookings. Can you just talk about how bookings did versus your expectation this quarter? I think the guide coming into Q2 was for about 40% growth. We came in at 42, clearly better, but a bigger delta on the billings versus the guide. And so can you just talk about how to read into that if there's anything to consider there with just those two kind of relation to each other?
spk19: Yeah, I don't, you know, I think obviously 42% bookings, you know, I think we've been over 40% now for three quarters, maybe four quarters in the bookings line. We feel really, really good about it. I think the one thing that, you know, we're looking at internally is just that the interplay between bookings, backlog, and billings and trying to really get a sense of, you know, what the direction of the business. And the example I kind of gave is we had a very good quarter on the mid-range of the product. But some of that was due to availability. Demand was very strong, but it was also because we had the mid-range product available. We didn't have as much product available in the low end. Now as we shift to this third quarter, I think we're probably going to see the low end availability improve fairly dramatically. And so when you're looking at buildings information that we have historically disclosed and trying to gauge the direction of the business, it gets a little bit distorted now just in terms of what's available. And I think of the total, when you look at bookings and backlog, there's some of that as well in terms of you know, the characterization of what the booking is versus the characterization of what's available to ship and what comes in the billing slide. Got it. Very helpful.
spk07: Thanks. Also compared to one years ago, maybe a tough comparison because we started to see that acceleration about five quarters ago.
spk13: Wonderful. Our next question comes from Adam Tindall, with Raymond James.
spk03: Okay, thanks. Good afternoon. Keith, you talked in the prepared remarks about still expecting supply challenges for the rest of the year and to offset your thinking, increase purchase commitments, qualifying additional suppliers, and pricing actions. I wanted to zoom in on that last point on pricing actions to see if you would maybe put a finer point on timing and magnitude for expected pricing actions. And secondly, you sounded positive on elasticity and confident on elasticity moving forward. But just curious what underpins that confidence, especially in international markets with dollar strengthening and local currencies and fixed budgets, et cetera. Thank you.
spk19: Yeah, great question. And I'll take the last one first because I think it's probably very important. I probably forgot the first one already. So one of the things that we do is we track very religiously in our CRM tool when a customer – if we lose a deal, we want to know why, right? Is it because we could not overcome the incumbency? Is it because the channel – partner may have had a bias, if you will, to one of our competitors, a feature issue, a functionality issue, or something like that. But also very specifically, do we lose on price? And we've been tracking that now for over a year. And that percentage, which is low, lower than the other ones that I just gave into you, has been extremely consistent. And so with that very consistent loss percentage, if you will, I translate that into price elasticity, which tells me that The question is always how far can you push the envelope? We know we come into the conversation with a significant price for performance advantage. The street sometimes or channel service may say 30% or 40%. We've known that from the beginning of this phase of the economic cycle, and the question has become how far can we push that? But again, keep in mind our goal is really to try over a longer period of time just match the cost increases and maintain a consistent margin. You know, it's not that we're really trying to take down more margin. Now, you will get volatility quarter to quarter because of the mix and things like that. So long-winded way to say I think I really hang my head on what I'm seeing and we're tracking on the CRM data about reasons that we lose deals and reasons that we win deals.
spk07: Yeah, and also a few other comments about pricing. Our policy tends to be – just by the price, by small step, but also kind of more often. Like, we do have a new price board, basically, released every quarter. Also, the other thing, really, like the product we released today, on average, for the same function, for the same price range, our product has a performance five to ten times better than competitors. Like Keith mentioned on the CIM on the tracking, we don't see any deal loss kind of changing. Even with deal loss actually improved because we still have a huge price advantage compared to competitors. The other thing also maybe mentioned to the surveys, I think one thing we may try to improve a little bit going forward is really even in the last few quarter, we increased some of the price more on the new product release. but we are not changing the price for the expired product. Basically, the product is still not having through the service like five, six years, right? So that's one thing we made because the labor cost on the service on supporting, so we may have to increase the price of even outdated product, no longer shipping, because all the service, all the renew, still tied to the old product, which is no longer shipping, but is the customer still buying the renew, buying the service based on the old product. So that's probably we can also help in improving the service and also helping the margin and compensate our additional costs, especially on the labor.
spk09: Very helpful. Thank you.
spk13: Our next question comes from Michael Turretts with KeyBank.
spk17: Hey, guys. So two questions. First, maybe it seems obvious in some ways, but do you feel like this is the first time that you've talked about this linearity issue as well as the extension of the negotiation cycles? So do you simply tie it to macro being worse right now, or do you have any other insights to it? And then I just wanted to make sure that in your mind, second question, you really think that it's really primarily services as a result of those things, the shortfall in the year, and you're happy with product.
spk19: Yeah. So I think the – well, putting aside the fat might where you broke the rule and you asked two questions and Peter said there's only one and a follow-up. Okay.
spk17: Oh, same idea. Sorry about that one.
spk19: I think what we're seeing in linearity, unlike a quote-unquote normal world where you can kind of look at linearity in DSO and can get a sense for whether or not a company is pushing to close deals at the end of the quarter and maybe it's a more challenging quarter, because of the timing of when the inventory is delivered from the contract manufacturers, we see a shift in that linearity of when we receive inventory from our contract manufacturers. that shift then translates into when we can turn around QA, et cetera, and ship it out to our customers and sell it. So there's a different aspect of linearity that's come into play here now. So service contracts that maybe would have been sold in the first month of the quarter actually got sold in the third month of the quarter, so we lose service revenue from that. And you see that appearing in the DSO, and you see it appearing in the free cash flow. On the negotiating side of it, You know, I think what we saw, and I don't know if this is, you know, common to Evers, but what we saw was probably the first two weeks of June, and maybe there was more conversation around recession and concerns there, if you will, you know, a bit of a pause in terms of deal closure rates for those first 10 days of June, and then a reacceleration as we got through the end of June. We did notice, or I did notice during that timeframe that maybe additional parties were being introduced to either as an approver or a negotiator, if you will, on some of the larger deals just to make sure on the customer side that they were making the right decision. And I think that's why I went on to say in the prepared remarks, not only did we notice this shift, but the close rates, which were important, actually were up just a tad in the quarter. So I think there was just, for whatever reason, there was a slight pause there for a couple weeks in June, and everybody came back and got the deals done on the customer side and our side at that last week in June.
spk07: The other reason for a little bit longer closing times is the bigger deal grows faster. So like I mentioned, the deal over a million dollars grows over 50% year over year. So that's the bigger deal also tend to take a little bit longer time to close. And also we see more like a deal involving multiple products, not just a 40K, but also we call it the non-affordability platform extension, which also takes a little bit long time to test, evaluate, to close. On the supply chain in Australia, compared to before the pandemic, we probably shipped majority, even most of the product by sea. Now we're pretty much shipping every product by air. That's where the timing of a supply, shipping a product to us, is pretty critical. for the linearity. And so last quarter, we do experience a lot of product being shipped in the end of the quarter from supply to us. That's drive the linearity. Even if we have the bargain, but we have to wait like a few weeks or even a couple months before the product was shipped to the customer more towards the quarter end because the supply should be to us pretty much in the end of the quarter. So we do see long-term, this will be changing, improving. We're keeping increase some of the product inventory. and improving the product turn and also balance among not just shipping everything by air, but some by air, some by ocean. Thanks, Gus.
spk08: Thank you, Michael. Next question.
spk13: Our next question is from Keith Bachman with BMO.
spk04: Hi, thank you. Good segue from Michael's question. Keith, I want to try to understand. You talked about a few different things. impacting the year guide. And to put context around it, your revenue guide for 22 isn't changing, which I think is viewed as a disappointment to investors. Now, underneath that, services revenue is getting compressed a little bit. And so as you think about why the revenue estimates are going higher for the year, is there a change in, A, the demand level, whether it's the elongation? Because you said, in fact, there was two weeks sort of week at the end of June, but it sounds like during the last, you know, through the 3rd of August, things have normalized. Or is it and or is it supply chain issues that are causing you to not raise your revenue guidances and you're, you know, raising billings modestly? I'm just trying to understand what are the forces that are impacting the lack of raise, if you will. Is it the demand side and or is it the supply side?
spk19: Yeah, I don't really think it's necessarily either demand or supply. I would start the conversation off by saying I think the pipeline growth is extremely strong. We feel very, very good about that. You know, I do think there's a fair amount of uncertainty as we look out, you know, beyond the third quarter to the fourth quarter in terms of, you know, directions the economies may go, what inflation may do, and a little bit of supply chain. You know, I don't think we did, as you point out, cover the shortfall, if you will, in the service revenue, economies may go, what inflation may do. and a little bit of supply chain. We did, as you point out, cover the shortfall, if you will, in the service revenue, in the product revenue. So I think that's a fairly good size of us being bullish and feeling very, very good about our competitive advantage. And I think that the other aspect we haven't talked about is just the large deals and how we're seeing the success in the enterprise and getting a little more dependent on large deals than we have in prior years and some of the close rates around those. I think that while we're bullish, we think we have competitive advantages. I don't know as we get through the fourth quarter, you know, if this is really a good time to think about that in a very, very aggressive fashion.
spk04: Okay. So can I just clarify? So it sounds like you want to be a little bit conservative or you don't want to get ahead of yourself on particularly the Q4 guide. So leave numbers where they are on revenues in particular.
spk19: Yeah. I think that's a fair description.
spk04: Okay, I'll see the floor, or else people will yell at me.
spk19: Thank you.
spk13: Our next question comes from Shaul Ayal with Cohen.
spk14: Thank you. So maybe, good afternoon, guys. Maybe segueing from the prior question and from revenue maybe to office. Your hiring plans appear to remain largely on track. What's the current thinking on second half? Is it becoming a little easier in recent months, given some layoffs with some private competitors?
spk07: Yeah, we want to maintain a healthy margin and then also keeping growing and gaining market share. I agree that hiring is relatively a little bit easier. compared to, like, a few quarters ago, especially in the cybersecurity space. So for us, we feel we have a good pace on hiring, especially if we still want to keep gaining market share. And, yeah, the margin is a healthy margin, basically, both on the growth margin and also on the operation margin side. So we feel... maybe have pretty solid planning and balance among the growth and margin.
spk19: Yeah, I think Ken's spot on with that. I would probably offer a couple of things to support it. One is, you know, you continue to hear us talk about our inventory commitments looking out now, you know, six quarters or more. You know, I think either read through that is that we still felt fairly bullish about it. And the other aspect of it, and Ken made reference to it, is, you know, we talk about 25% operating margins in different ways over the years, you know, as being an average, a target, what have you. And obviously, you know, in this environment with high inflation, to come in successfully and still be providing guides for the full year of 25% to 26% while growing the top line aggressively, while taking market share, I think we feel very good about, you know, how the sales team, the engineering team, the operation teams, support teams, et cetera, are all working together and driving the growth of the company, the execution.
spk08: Thank you, Joe. Next question.
spk13: The next question comes from Hamza Faderwala with Morgan Stanley.
spk18: Hey, guys. Good afternoon. Thank you for taking my question. Maybe a question for both Ken and Keith. Ken, just given the general pressure on budgets in the macro environment, are you seeing a little bit more impetus from customers to want to consolidate to a convert security networking platform like a Fortinet? And then for Keith, if you're seeing any, let's say, elongating negotiating cycles and whatnot, is it more weighted towards the core platform FortiGate side or the platform extension side with those switches and access points? Thank you.
spk07: It's a very good question. Definitely, we see the convergence among the network and security. Also, the pandemic accelerated this kind of change, especially inside a company, a compass network, and also work from remote anywhere. So that's where we see the pretty strong growth. And also a lot of connected device, like in the OT space, also we see very strong growth. Like we mentioned, I see one growth 60% and the OT growth 75%, and we're still keeping growing, gaining market share there. And at the same time, have to secure the whole infrastructure not only expanding on the network security to the networking side, but also beyond the network security, with Endpoint, with the cloud, with all the other application level, from email, web, all this, all working together. So we do see all this. We keep saying the convergence and the consolidation will benefit for that multiple year going forward. It's more long-term growth driver for us. And we prepare this in the last like 22 years since start a company with the investment like from ASIC technology for the R&D with the most product internally developed to integrate, automate together. And so we do see that time is starting coming. And for all this investment, starting to see some good return. And also, we feel we have a very healthy business model. Since IPO, now it's about 13 years now, we want to maintain the balance of growth and also a healthy margin. And that's what makes the company last longer. And at the same time, we're also kind of keeping investing in the long term to follow the change and also keep up the innovation and quickly customer benefit from our innovation and also long-term investment.
spk19: And, Hamza, I think your speculation about where the larger or the timing comes in is accurate in that it's going to be in that one-third of our business that is the large enterprise. One, the dollars are larger, obviously, and so they're going to have customers spend a little more time with the ROI. But I think more importantly, and to your second point you conjectured on, by adding in more of the platform products into a deal, you're perhaps a little more likely to run into additional competitors or people internally that are champions of those competitors. And so there's a little more that it takes to get across the finish line because they are more complex in that way. I'll fill the void here by the next question. As a reminder, we did 122 deals over $1 million in the quarter, which that's a pretty fantastic number for us.
spk13: Our next question is from Gray Powell with BTIG.
spk10: Okay, great. Thanks for taking the question. So, Keith, I know you hit on this once or twice already, but I just want to make sure I understand a dynamic on the services billings. So if I back out product revenue from short-term billings, it looks like the annual recurring component of billings actually accelerated pretty nicely. I'm calculating like 29% in Q1, improving to 40% in Q2. I don't need you to bless the numbers, but directionally, does that seem right to you? And then if so, how much of that was driven by pricing dynamics that you talked about versus just the natural cadence of the business?
spk19: I do think your math is directionally correct, but I want to spend a lot more time to give you more about how accurate it actually may or may not be because kind of looking at it a different way. And I would say, again, if you think about the timing of when a price increase is affected, right? It's got to go through the process of being pre-announced to the channel partners. They get, I think, 60 days of advance notice. And then when does it actually start to have an impact on it? Keeping that in mind, you do see the impact on pricing actions fairly quickly on product revenue and on billings, whether it's a product or whether it is a service item. You will see it there. But on service revenue, you won't see that benefit for an extended period of time. And I think one thing that may help people, if you think back of our shift from 8x5 support to 24x7 support, we talked about that for several years. Because when we turned off the 8x5 support, with that came a price lift. And the question that we were addressing, it seemed for eight, 12 quarters, probably in a row, was how was that mix shifting and how was that coming into it? And we were providing information back then about all the billing, so to speak, are under 24x7, but you're not seeing the revenue mix that way because that mix has to evolve over time as you go through the install base. Price increases for service revenue, this is just another flavor of the same thing that way. you're going to see the benefit over a much longer period of time on the service revenue line. You will see the benefit in billings much sooner, and that's why we gave that information earlier, and you're looking at it. That's a very good leading indicator of where service revenue growth is going to go in the future.
spk10: Okay, that's really helpful. And then just a real quick follow-up. You mentioned a $25 million headwind on service revenue from Russia, which is a new headwind. Does that apply to billings as well, or was that purely a revenue dynamic?
spk19: That was a revenue dynamic, and I would probably say 40% of that probably. 30% to 50% of that would have been a billing dynamic in terms of where we were from the beginning of the year where we'll end up now.
spk09: Got it. Okay. Thank you very much.
spk02: Next question.
spk13: Our next question is from John Weidmoyer with William Blair.
spk02: Hi, this is John Widenwood for Jonathan Ho. Thanks for taking my question. On your platform extension, cloud security capabilities, I'm curious of the type of customer profile that's interested there. I suspect they're probably an existing Fortinet customer that's transitioning to the cloud. And I'm curious if there also may be a fabric mesh, so there might be an all-in customer, an all-in Fortinet-type customer. Can you talk about the characteristics of the people that are going that route?
spk07: Yeah, we do see the cloud security growing well. pretty much on a similar pace as how other networking appliances grows. And also, we do see a lot of cloud security come from the service providers, especially carrier service providers. Some of them also combine with an offer SD-WAN, some also with OT, all these together. So that's what we're keeping saying. For better security, They need to secure the whole infrastructure, not just the cloud, but also our pines and some other part of the infrastructure. So we do see more and more customers want to consider all overall together. So basically, cloud security also drives a lot of other part of cybersecurity, other part of infrastructure for cybersecurity. And also, we do believe long-term the service provider, both in the telecom space, also in the security system integrator, And also, like, even the cloud provider will play a very important role on this security, especially in the service part. And that's where we also want to keep supporting them. So that's where we see that it's kind of a still more hybrid environment going forward, and especially with more and more devices connected with a lot of other We see kind of the whole infrastructure security kind of more and more important. Consider all part of security together is quite important.
spk13: Our next question is from Greg Muscowitz with Mizuho.
spk00: Okay. Thank you for taking the question. Good afternoon, guys. I'd like to ask about your backlog, which has significantly and consistently increased over each of the last three quarters. It's dramatically above year-ago levels. So, Keith, you've made it clear that the backlog should further rise by year-end, which is great, but at the same time, it's not going to grow forever, and it's common to see dips in a company's backlog due to seasonality, significant order shipments, cancellations, etc., And so it would just be helpful to get your sense of perhaps when we begin to see ebbs and flows in the backlog metric. If you could offer anything there, that would be helpful. Thanks.
spk19: I think the question is when the supply chain is going to get better, Ken. So I'm going to let you handle that one.
spk07: If you compare to end of Q1, we increased backlog 120-some million. And then end of Q2, we increased about 72 million. It's a little bit better, increased less than end of Q1 and also less than end of Q4. So there's some kind of improvement on increased backlog. But also, we put a lot of effort to sourcing different parts from different vendors, design products. You see the product line, we got quite broad right now, and also can help in leverage some kind of, I mean, some alternative or kind of a more broad supply chain for us. So that's why I do believe, because the demand is still very, very strong. And so we do see, since probably keeping get a little bit better and better. But like I keep saying, we probably not expect the backlog will reduce in Q3, Q4, but the increase probably will be less each quarter, I put it this way. And then maybe next year we're starting to see some kind of improvement with the backlog. But overall, with our engineering effort, with the kind of But the investment we made in the operation in the manufacturer, we do see since then, it got improved a little bit better now.
spk19: Yeah. Makes sense. I think it's a logical place to have questions, and I think Ken's comments are great. I would just add to that, keep in mind the – and this is why we provide some of the metrics there. We're not – these are not airplane orders, right? These are relatively small dollar items by comparison to what you may see in other industries. And that's why we gave some of the metrics on the sizes, if you will, and the fact also that they're existing customers, and many of those have been partially fulfilled. And we all have the same concern, and the question is, you know, how do you get comfortable that that backlog, you know, is sticky and it's going to be here when the product and the supply chain loosens up? And that's why we're giving those metrics for people to get some sort of context. But I would keep in mind, you know, these are comparatively to other industries, construction industry, airline, what have you. You know, these are very small dollar amounts.
spk07: Also, the age of our backlog is probably much better than our competitors. Like Kiki mentioned, in the last two, three quarters, every quarter, even we increase the backlog and we fulfill probably like 60%, even over 60% of previous quarter backlog. So that's making our age in our backlog also pretty short, a few months compared to most other competitors. Sometimes it may take one to two years to deliver. So that gives us a pretty good position and also the customer trust. continue working with us during this supply chain issue. And at the same time, we offer quite a broad product. There's always some kind of alternative product we can suggest our customer to use if one or two products have shortage.
spk00: Very helpful, Collar. Thank you both.
spk07: Yeah, I think we deliver over 90% of any bulking at every quarter, I believe.
spk08: Yeah, the bulking is between zones, yeah.
spk07: Between 90% to 95% of the bulking, we do deliver the product. Thanks, Greg.
spk13: Our next question comes from Andrew Nowinski with Wells Fargo.
spk06: Okay, thank you for squeezing me in, and congrats on another great quarter. I had a question on free cash flow. So I think you said you expect the low-end supply of appliances to dramatically improve in Q3. So is there a margin or free cash flow impact that makes shift in Q3? And then related to that, You know, given the shortfall on services that we saw in Q2 and the negative impact it had on your free cash flow, should we expect free cash flow to rebound in Q3 and Q4? Or are you assuming the linearity remains unchanged in those quarters? Thanks.
spk19: Yep. I'm assuming the linearity is, I don't really have any reason to think that's going to be any different. I'm looking for a reason to find, but I certainly have not found one yet. So, you know, when we look at what our expectations are internally and what we don't guide to free cash flow, we try and give information that's helpful to others. I would assume that – I have no reason to assume anything other than we'll still see more of the same, if you will. And I think the first part of your question was you asked about low-end and about margin, and maybe I can offer a little bit of commentary there. When you look at our FortiGate firewall product families, the entry-level or low-end, as you call it, mid-range and high-end, in general the margins increase, the gross margin increases as you move up from the entry-level to the higher end of it. So from that aspect of it, and that's why the comments in the script that there can be gross margin volatility, both from the pricing actions that we've taken and the discounting as well, but also the mix of our product. So in a quarter that we see a higher mix of higher end firewall shipments, margins will be higher by definition. But there's many puts and takes in there that when we go through the gross margin guidance that we give, hopefully we're considering all the different puts and takes that are in there, not just the mix of the mid-inventory and the pricing actions.
spk11: Thank you.
spk08: Operator, last question, please.
spk13: Our last question comes from Roger Boyd with UBS.
spk15: Hey, thank you very much for taking the questions. Keith, I was curious, just to go back to the backlog for a second, you had mentioned the split being about 50-50 between FortiGate and networking portfolio. Just wondering if you could talk about how you expect that mix to trend through the end of the year, and I guess the follow-up to that is what you're seeing around the supply constraints between those two product portfolios. Thanks.
spk19: Yeah, I might double-check the numbers. I think it was 50%, 50-40 between Florida Gates and networking equipment. I have it backwards. Networking equipment is 50% and firewalls are 40%, and then caps and dollars are the remainder of it. I think everything that we seem to read and hear, and Ken probably knows more, the pressure certainly seems to be, for lack of a better term, more intense on switches and access points than they do on firewalls, and for a lot of the reasons, I think we're more successful with firewalls.
spk07: Yeah, I agree. Probably direction-wise, we do see the 40K inventory will keep improving, so probably the percentage may be a little bit more, on the backlog, probably a little bit more towards the the switching and AP side, which is probably the whole industry is suffering some of the supply issue. The full gate, because we are more able to redesign and also use our own ASIC, which is also helping kind of reduce the backlog and supply on time for the customer. But from the beginning of this backlog issue almost one year ago, definitely we see the shift in a little bit more towards the networking side, so I'd have a little bit longer backlog.
spk15: Very clear. Thanks for the call. Thank you. Thank you.
spk13: I would now like to turn it back to Peter Salkowski.
spk08: Thank you. I'd like to thank everyone for joining the call today. For that, we'll be attending investor conferences hosted by KeyBank, Citibank, Evercore, Stifel, and Goldman Sachs during the third quarter. Fireside chats will be available through our IR website. Please let me know if you have any follow-up questions. Feel free to contact me and have a great rest of your day. Thank you very much.
spk13: Thank you for your participation in today's conference. This does conclude the program. You may now disconnect.
Disclaimer

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