Fortinet, Inc.

third quarter earnings conference call. At this time, all participants are in the 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, that's star 1-1 on your telephone, and you will then hear an automated message advising you that your hand is raised. Please be advised that today's conference is being recorded. And without further ado, I will now hand the conference over to your first speaker, Peter Salkowski, Vice President of Investor Relations at Fortinet. Peter, please go ahead.

Thank you, Eric. Good afternoon, everyone. This is Pete Salkowski, Vice President of Investor Relations at Fortinet. I am pleased to welcome everyone to our call to discuss Fortinet's fiscal results for the third quarter of 2022. Speakers on today's call are Ken Zee, Fortinet's founder, chairman, and CEO, and Keith Jensen. our Chief Financial Officer. This is a live call that will be available for replay via webcast on our investor relations website. Ken will begin today's call by providing a high-level perspective on our business, then follow with a review of our financial and operating results for the third quarter, providing guidance for the fourth quarter, and 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 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 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 our GAAP to non-GAAP reconciliations are located in our earnings press release and in the presentation that accompanied today's remarks, both of which are posted on the Investor Relations website. Ken and Keith's prepared remarks today for today's earnings call will be posted on the quarterly earnings section of the Investor Relations website immediately following today's call. Lastly, all references to growth are on a year-over-year basis and less than noted on the lines. We will now turn the call over to Ken.

Thanks Peter, and thank you to everyone for joining today's call to review our outstanding third quarter 2022 results. Revenue for the quarter grew 33%, significantly outpacing the energy growth rate. We believe that customer recognition of the exceptional value proposition we provided by our high performance 40ASIC technology and an integrated 40OS operation system is driving our ability to take cybersecurity market share. Product revenue growth was very strong at 39%, extending our position as a product revenue leader in the cybersecurity industry. Our product revenue performance reflects the strong demand we have built over the past 18 months across our security solutions, along with the successful execution of our internal team in managing the supply chain challenges. Three growth drivers, the heightened threat environment, the convergence of security and networking, and the consolidation of security functionality and vendors, together with the opportunity to upsell additional security services to a significant installed base, are expected to drive future growth. First, the threat landscape, including ransomware, continues to expand and evolve in targeting companies of all sizes, locations, and industries. To counter the threat landscape, We are implementing our unique universal ZTNA across a wide range of customers, driving triple-digit growth for this product and delivering a comprehensive approach to zero trust that is consistent for any user anywhere on any device and supporting today's hybrid workforce. Second, for years Fortinet has lead strategy around convergence of a networking and security We estimate the total addressable market for networking and security will increase from $54 billion today to $73 billion in 2026. Convergence accelerates digital transformation and substantially reduces operation costs by combining networking modelization with dynamic security that seamlessly spans every part of a network, especially now that many companies are merging ICOC and IOC operation together. Fortinet is leading the convergence trend with a wide range of technologies, including network firewall segmentation, secure SD-WAN, OT security, and 5G in a single operation system, which can be deployed as hardware, software, cloud, and as a service. Fortinet continues to gain secure SD-WAN market share, as our integrated Secure SD-WAN solution delivers better security, performance, and efficiency over more traditional offerings. In a quarter, SD-WAN and OT bookings grow over 45% and 75%, respectively, and together accounted for over 25% of total bookings. We believe we can achieve number one market share in SD-WAN in the next couple of years. Today, we announced the FortiGate 1000F, our latest innovation in converging networking and security. Powered by our new MP7 SPU, the 1000F delivers five to ten times higher performance across six major network security functions by consuming 80% less power, much as competitive solutions. The lower power consumption was a contributing factor in our top 2% ranking in SMP global corporate sustainability assessment. Our third growth driver is the consolidation of our vendors and the product functionality. With FortiASIC's huge computing power advantage, FortiOS can integrate more secure functions than our competitors, together with over 30 key products ranging from endpoint to network to the cloud security. Fortinet provide our customer with easier operation while lower the management costs and the total cost of ownership. Additionally, we were focused on upselling value-added security services to a significant customer base. According to IDC second quarter union share data, Fortinet hold a number one market share position for union ship and 43%, up 210 basis points. We expect to reach 30% market share in the next few years. This leadership position and the substantial installed base create attractive economy of scale and an opportunity to upsell additional security services. 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.

All right, thank you, Ken, and good afternoon, everyone. Let's start with an overview of our strong third quarter performance. Revenue of $1.15 billion was another quarterly record for Fortinet, increasing 33% year over year and 12% sequentially, our highest third quarter sequential growth rate in 11 years. We continue to deliver better than industry average top line growth and generate strong profitability. Our operating margin exceeded guidance at over 28%. driving the adjusted free cash flow margin to 40%. Our history as a public company has revolved around the rule of 40, measured as the combined total of revenue growth and operating margin. Impressively, the Q3 total came in at over 60. We continue to see success in our strategy for expanding further into the large enterprise segment. The number of deals over $1 million increased over 80% to 153 deals. The total billings value of deals over $1 million more than doubled, driven by a record number of deals over $5 million. And G2000 bookings increased over 40%. Our strong third quarter results reflect solid customer demand across both our core and enhanced platform technologies and the exceptional performance of the team in a challenging supply chain environment. We believe the investments we've made in building our platform and our go-to-market engine enables our customers' digital transformation journey Our platform strategy allows customers to converge networking functionality with security capabilities while consolidating cybersecurity products, providing security across their entire digital infrastructure while lowering their operating costs. Recently, the Forrester Wave Enterprise Firewalls Report acknowledged the success of our investment strategy, placing Fortinet as a leader for the first time in its history. According to Forrester, end quote, Fortinet excels at performance for value and offers a wide array of adjacent services. Long known for its bang for the buck approach to network security, Fortinet has built a flexible and capable platform with its flagship product, the FortiGate firewall. Taking a closer look at the income statement, product revenue grew 39%. Product revenue growth for our core and enhanced technology platform products increased 29% and 51% respectively. The product revenue growth rate accelerated over four points sequentially, especially in Preston, given it is our toughest year-over-year comparison in over 10 years. Service revenue was up 28%, accelerating three points sequentially, driven by strong product revenue growth and seven consecutive quarters of increasing short-term deferred revenue growth rates. Support and related service revenue was up 28%, accelerating over two points sequentially to $311 million, while security subscription service revenue was up 29%, accelerating four points sequentially to $370 million. Total revenue in the Americas increased 34%, EMEA revenue increased 37%, and APAC posted revenue growth of 23%. Total gross margin at 76.2% exceeded the high end of our guidance range. Product gross margin of 61% was up 30 basis points year over year. Services gross margin of 86.6% was flat year over year, but up 70 basis points sequentially. Operating margin of 28.3% was up 250 basis points, benefiting from FX and the operating margin leverage that comes with higher revenues. Shifting to billings, billings of $1.4 billion were up 33% representing the sixth consecutive quarter of billings growth in excess of 30%. Core platform billings were up 27%, and accounted for 67% of total billings. As shown on slide 6, entry-level Florida gates posted very strong billings growth, with the mix shifting 16 points in their favor, driven by demand, and as we expected, improved supply. Enhanced platform technology billings were up 45%, and accounted for 33% of total billings, a positive makeshift of three points. Average contract term was flat year-over-year at 29 months. Looking at the statement of cash flows summarized on slides seven and eight, free cash flow was 395 million. Adjusted free cash flow, which excludes real estate investments, was 464 million, representing a 40% adjusted free cash flow margin. DSOs were down five days sequentially, while increasing 12 days year-over-year to 75 days. Cash taxes were $69 million. Capital expenditures were $88 million, including $69 million for real estate investments. We repurchased 10.2 million shares of our common stock, with a cost of $500 million, bringing the year-to-date totals to 36 million shares at a total cost of $2 billion. The remaining repurchase authorization totals $530 million. Regarding backlog, the backlog at the end of the third quarter was up slightly from the end of the prior quarter, with FortiGate firewalls accounting for just one-third of total backlog. We expect fourth quarter ending backlog to be relatively consistent with the third quarter backlog, as we are seeing early signs of a transition back to more normalized customer buying behaviors. Moving to guidance, The current environment favors a Fortinet-style platform that offers integrated solutions and strong security capabilities at an attractive cost of ownership. To enhance our ability to capture our share of the large market opportunity, we plan to continue to invest in innovation across our integrated platform offerings. Now I'd like to review our outlook for the fourth quarter, summarized on slide nine, which is subject to disclaimers regarding forward-looking information that Peter provided at the beginning of the call. And to start, as part of the Q4 guidance setting process, we considered several factors, including the greater macro uncertainty today, and with it, the increased risk of forecasting the timing of certain larger transactions. The transition to more normalized customer buying behaviors, which means there is less of an emphasis on ordering to get a place in line. And for comparison, in the fourth quarter of 2021, when supply was tighter, backlog increased over $120 million, and contributed to 49% bookings growth. And lastly, elevated year-earlier top-line comparisons that include certain one-time items adding a couple of points to service revenue growth and fully cycling the Alexa acquisition. In response, we have slightly widened our top-line guidance ranges. For the fourth quarter, we expect to again reach the rule of 60. And with that, the key metrics include billings in the range of $1,665,000,000, to $1,720,000,000, which in the midpoint represents growth of 30%. Revenue in the range of $1,275,000,000 to $1,315,000,000, which represents growth of 34%. Non-GAAP gross margin of 75 to 76%. Non-GAAP operating margin of 30 to 31%. Non-GAAP earnings per share of 38 cents to 40 cents which assumes a share counted between $795 and $805 million. We expect capital expenditures of $75 to $85 million. We expect a non-GAAP tax rate of 17%. And for the full year, we expect billings and revenue growth to exceed 30% for the second consecutive year. Billings in the range of $5,540,000,000 to $5,595,000,000, which at the midpoint represents 33%. Revenue in the range of $4 billion, $410 million to $4 billion, $450 million, which represents growth of 33%. Perhaps for context, we should note at the midpoint, these full-year billings and revenue growth rates are three points higher than the initial growth rates we provided in early February. Despite the start of the war in Ukraine in late February, significant increases in interest rates and increasing uncertainty in the macroenvironment, And importantly, full-year backlog is expected to be above the February estimate of $350 million. Total service revenue in the range of $2,645,000 to $2,655,000, which represents growth of 27%, and applies full-year product revenue growth of 42%. Non-GAAP gross margin of 75% to 76%. Non-GAAP operating margin of 26% to 27%. At the midpoint, a year-over-year increase of 30 basis points. And again, for context, at the midpoint, gross and operating margin expectations are 50 and 100 basis points above the February guide, respectively. Non-GAAP earnings per share are $1.13 to $1.15, which assumes a share accounted between $800 and $810 million. We expect full-year capital expenditures of $325 to $335 million. We expect our non-GAAP tax rate to be 17%. We expect cash taxes to be $265 million. Before wrapping up, I'd like to offer some preliminary thoughts on 2023 and our mid-term targets on the heels of a very strong set of growth in 2021 and 2022. We continue to successfully balance growth and profitability while investing in longer-term innovation and go-to-market initiatives to fuel future growth. The strength of our business model includes its diversification, margins that provide capacity for future investment, and a rich mix of higher margin recurring service revenues. As we saw in the height of the pandemic, the diversification helps mitigate the risk of economic slowdowns. Specifically, in 2020, we delivered operating margins of nearly 27%, adjusted free cash flow margin of over 38%, and top line growth of 20%. And during the past 12 months, we have really exceeded our operating margin targets while increasing our engineering headcount by about 20% and significantly increasing our future sales capacity by over 25%, including a greater than 50% increase in new non-tenured salespeople. While we will provide more detailed 2023 guidance when we report our fourth quarter results, it's worth noting that service revenue accounts for 60% of total revenue with gross margins hovering above 85%. We see continued service revenue growth driven by two years of very strong product revenue growth and seven consecutive quarters of accelerating short-term deferred revenue growth. With a strong business model and a history of being able to execute, we are confident that our momentum will continue and point to our key growth drivers, including strategic investments, the heightened threat environment, the convergence of networking and security, and cybersecurity consolidation. Cybersecurity, though not immune to economic slowdowns, is expected to remain a relatively safe harbor. As such, we remain on track to achieve all of our medium-term financial targets from our May 2022 analyst day, including $10 billion in billings and $8 billion in revenue in 2025, each representing a 22% three-year CAGR from the midpoints of our 2022 guidance. The targets also included an average non-GAAP operating margin of at least 25% for the four years from 2022 to 2025, and a 2025 adjusted free cash flow margin in the mid to high 30% range. Illustrating our long-term focus for balancing growth and profitability, our targets remain committed to the rule of 40 or better. I'll now hand the call back over to Peter to begin the Q&A.

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. Eric, we are ready for the Q&A.

Excellent. And also, as another reminder, if you want to ask a question, press star 11 on your telephone and wait for your name to be announced. Okay, please stand by while we compile the Q&A roster. And our first question comes from Fatima Bulani at Citi. Fatima, your line is open.

Thank you. Good afternoon. I appreciate you taking my questions. Keith, this one's for you just with respect to the 4Q guidance and the outlook. Appreciate you kind of breaking down the three principal factors that went into that. But I wanted to dig in specifically on the comment you made about normalized buying behavior as it relates to the backlog build. So I think what I inferred from your comments is that while the backlogs is going to be sequentially up and sort of higher than what you initially pointed out to be maybe $350 million of ending backlog. That's certainly below the $500 million that you were previously telegraphing. So I just wanted to better understand sort of the modulation downward on the backlog there and how the sort of normalized buying behavior contributes to that. And then I'll ask my follow-up.

Okay. I think when we talk about normalized buying behavior, I think that we certainly saw some enterprise customers in the U.S. during the supply chain challenges that were placing orders to get in line, to hold their place in line for when inventory is available. And I think, say, a year ago or so, that that was an appropriate behavior when there was a lot of uncertainty around the supply chain, and maybe they were planning for what they were going to do in 2022. I think that somewhat in general now, and maybe Ken will talk more about this, I think people are getting the sense, certainly we are, that the supply chain is a little bit easier to forecast and somewhat easier to manage. I don't mean by any stretch easy, but I do think it's easier. And with that, I think you're starting to see the market drift back towards, and I emphasize start, to what I would call more traditional buying, which is when they need it, they're placing the order.

Yeah, and also look at the composition of a backlog. It's only one-third or less related to our network security platform, 40K. More than half related to like a switch and AP, which is a networking equipment, which is a kind of an industry problem in the networking side because the networking device tend to be more exchangeable, more standard-driven. So a lot of customers sometimes double, triple order. try to get ahead of whatever the supply chain issue and also some of them can easily cancel once they got a product. So that's what we feel probably keeping track in the backlog may not be the best way to forecast the business. And we should be more focused on security, security related, especially driving the future service based on huge 40-gauge installation base.

Thank you. And Keith, just a clarification on the services revenue trajectory and more broadly thinking about next year. So we saw the reacceleration this quarter in services revenue. So wondering if you can give us a quick update on how the delayed registrations from earlier in the year and transactions from earlier in the year are trending and how we should think about that filtering and flowing into our models for next year. Thank you.

Yeah, I think we've been messaging throughout the quarter, various conferences, and even in the prior quarter, that we had a clear expectation that service revenue growth has accelerated, so we're very pleased to see that. I think there's a number of things that are providing a tailwind into that. Customer registering units is part of that. I think also the price increases making its way first into orders and deferred revenue and now into the income statement, keeping in mind that we have contracts that sometimes are as long as five years. That will give you a sense of how long the tailwind may relate to price increases as we will continue to cycle through renewals at old prices and replace them with new contracts. So I think we feel good about the direction of the service revenue and the margins that it provides together with the fact that it's 60% of our business.

Okay, thank you. Our next question comes from Socket Kalia at Barclay. Socket, your line is open. Please go ahead.

Okay, great. Thanks very much for taking my question here. Keith, maybe just to start with you, I'd love to just zero in on product revenue growth a little bit for this year. Can you just maybe talk about some of the growth drivers for product revenue this year that aren't expected to repeat next year. Again, very helpful detail kind of thinking about total billings for kind of following years. But for product, what are some of the one-off things that we should be keeping in mind, like an Alexala, like price adjustments, just to sort of think about what normalized growth in product might look as we start to think about the following years?

Yeah, I think Alexula is probably the easiest one to talk about in terms of providing numbers. We've talked about the fact that their revenue stream is probably something on the order of $130 to $140 million when we acquired them and reminded people that they are a March 31 year end, so their fourth quarter is a little bit off cycle. I think that its growth is single digits, so I think that probably gives people a good level of expectation. A reminder there that Our interest in the Alexa lab is a lot around the IP and some opportunities that we have there to do things more longer term, if you will. In terms of other unique things about product revenue in the quarter, I mean, I think that, you know, as the backlog comes into revenue, you know, as we go through the end of 2022 here and certainly into 2023, you know, it's going to provide, again, a fairly significant tailwind to what the product revenue growth will be.

in 2023 assuming we get that the drawdown and backlog that we may see yeah also we we believe the the growth driver especially the converged network and security we don't think in that slow down we'll be keeping driving the product growth in the next five to ten years you can see the the security one and ot both has pretty healthy growth and the same time what will continue to growth in the next five to 10 years in a huge market potential.

Got it. Got it. Maybe for my follow-up, really for both of you, I'll make a jump ball here. I think in Q3, we had operating margins of about 28%. I think the guide for Q4 is for margins a little bit higher. When I think that long-term guide out to 25% of at least 25%, it feels like you're doing a lot better than that here in the near term. Maybe the question is, how do you sort of think about that balance, right, in terms of growth maybe moderating or normalizing, as we mentioned, versus sort of that long-term margin?

I think that's where, if you look at the circling year history, we as a public company, we always balance the growth with the margin. So that's where we feel that 25% above is a healthy margin And then we can also give the money to invest in the growth, become a leader in the space. That's where we're continuing to balance. But if the growth slows down, definitely will be more helping in the margin. So that's why we keep saying the rule of the 40, probably in the last few quarters, we kind of even reached the rule of the 60 now. So that's where also when the growth slows down and sometimes the service revenue has a higher margin, which can also help in the margin, but we do expect The growth will continue in the next few years with the three growth drivers I mentioned and the plus additional service revenue to our big installation base. A lot of them are not quite able to secure the service revenue yet.

Yeah, I would probably sort of agree with Ken and Alfred just a little more detail on it. Keeping in mind that we sell in U.S. dollars, so there's really not a direct FX impact there on the revenue line. Obviously, you can get into certain countries where that The pressure on discounting, if you will, because our exchange rates can be a little more intense. But on the OpEx, you know, because 30% of our business is the U.S. and the rest is international, you know, we do get a tailwind from OpEx from the strength of the U.S. dollar. And I think you're seeing that in Q3 and you're seeing that in Q4. And probably why it's important is that, you know, we've talked for a number of years now around and made reference to 25% operating margin. If you go back four years ago, five years ago, it was probably a target to get to 25% operating margin. And since then, we've talked about averaging 25%, setting a floor at 25%. It has certainly served us well as a way to help other people understand about how we invest in the business, and as Ken makes reference to it, as we have funds available over that 25% operating margin, it creates opportunities for some, not necessarily all, as you're seeing currently, of those margin dollars to be reinvested back in innovation and back into our go-to-market strategy.

Got it. Very helpful.

Thanks. Okay. We're just lining up the next question. And the next question comes from Hamza Fadarwala at Morgan Stanley. Hamza, your line is open. Please go ahead.

Hi. Good evening, Vince. Thank you for taking my question. Keith, on the backlog, You know, I appreciate, look, sometimes, you know, you have too many metrics. That creates too many noise. And on the supply chain front, it seems like it's getting a bit clearer. But could you give us any more granularity on how that backlog and that booking trajectory looked relative to your guidance, which I think when you guided to it, you were saying about 36% growth at the midpoint for booking. So just curious how that shook out in Q3.

Yeah, I think I'll come back to kind of Ken's commentary around backlog, which is really what kind of drives the conversation about bookings. I think a year ago when we introduced the backlog metric, there was a lot of uncertainty around what the supply chain crisis was going to look like and how it might impact our business. And the purpose of providing the backlog disclosure and the booking disclosure then was to kind of round out and help investors understand more about our business model as we go forward. And as we heard in a question earlier from one of the questions, you know, at the beginning of the year, you know, it kind of swagged, that kind of swagged backlogged growth at $350 million in the first quarter. And then it came back and said in the second quarter, maybe, you know, it's going to get closer to $500 million for the full year. And now I think we're looking at a number that's, you know, going to be less than that. You know, something in the fours probably seems reasonable from where we're at. And I think when that net, the message, there's two messages. So one is I think we're becoming much more comfortable with our ability to execute in this environment and maybe some easing in the environment itself. And then secondly, I think that it was always our intention, and I think we messaged this, that these would be short-term metrics that we would provide. And I think they've served us and our investors well for an extended period of time. But it's probably time now that we feel that we've gotten a better control on it to bring us back in line, if you will, with what our industry competitors are disclosing and not disclosing.

Makes total sense. Just to follow up really quickly, I mean, is it fair to say that your bookings growth is still higher than your billings growth? Obviously, your backlog grew, so you're still expecting underlying bookings to be higher than 30% this year.

Yeah, we're not going down to the detail of parking specifically about bookings, as I just mentioned, going forward, nor backlogging more than what we've given to this point.

Okay, thank you.

Okay, our next question comes from Rob Owens at Piper Sandler. Rob, your line is open. Please go ahead.

Great. Good evening. Thanks for taking the question. Just one from me. Curious with the supply chain getting a little bit easier, how you're thinking about gross margin, both kind of in the short term as well as the medium term. Thanks.

I think the component and also the cost continuing to go up. Uh, so that's where, and also we still have a pretty tight, uh, even trade to, to make most of shipment shipping by air instead of by ocean. Uh, so that's where, uh, so we're, we're, we're keeping, uh, just by, uh, thought it's a cost and, uh, probably some of that we eat ourselves. Some of them we may, uh, do some price increase, uh, but we also feel. Even some price increases, we continue to have a price advantage compared to the industrial average with our products. So that's where the margin, we feel, probably will be more stabilized. And that's probably the overall supply probably keeping improving.

Yeah, again, spot on with that. Probably a little more granularity. Yeah, I think if you maybe look at it between product gross margin and services gross margin, the product one is the one that's probably more volatile related to what we're seeing. We've certainly heard commentary that maybe things are easing a little bit with the chip manufacturers, but I would say that there's no indication any sort of cost reductions or savings that are coming from either the chip manufacturers or the component suppliers. So we'll see how that plays out. Our strategy has been, and Ken alluded to this, is that we came into this this economic cycle a year ago, believing that we had a price and performance advantage and that we could raise prices. And our target was really to pass along most but not all the price increases, call it plus or minus 1% margin. It's kind of our target every quarter. It doesn't fall that way every quarter because of various variables. And I would imagine that to the extent that prices can remain elevated as we move into 2023, that's kind of the starting point for our pricing strategy into 2023 as well. Again, because we have not seen signs that we've lost the price for performance advantage. In fact, we continue to win that way. Service is a little bit different. I mean, the largest cost component in services is labor. And if you look back, you know, we're a company that has its annual merit increases in the first or second month of the year. So you kind of get a rather immediate jolt on the COGS line from the compensation increases, which is certainly appropriate. And then you have to grow the service revenue into it. And I think that's part of the conversation about why you saw the reference to sequential margin increases. On the revenue side, it gets fairly complex. Well, maybe not complex, but thinking through how price increases that started about a year ago and kind of hit a quarterly pace, if you will, how those price increases will make their way first onto the balance sheet in deferred revenue. and to what extent each item is going to reflect all those price increases, and then how it will come off the balance sheet in future periods. So you will get tailwind from the price increases, and I would expect that that particular tailwind should continue for an extended period of time.

Ken and Keith, thank you.

Okay. Our next question. Just connecting the line now. Comes from Saul Eyal at Cowen. Saul, your line is open. Please go ahead.

Thank you so much. Good afternoon, guys. Keith, question on APAC. Softest performance in, I think, like two years. What was driving that? And I have a follow-up.

Yeah, I think we've made a leadership change there consistently. around the end of June, beginning of July, we had a retirement. And I think that's, you know, just kind of the transition of leaders, if you will, as one was exiting into retirement and we brought somebody on that I think we feel very, very good about in terms of their abilities. And I think the other part of it is, you know, you're starting to see the lapping effect of Alexa because all of Alexa is sitting in APAC. And so you're going to see that now as we roll up on basically the full quarter comparisons.

Understood, understood. And on 40-git sales, maybe looking at it from a tier perspective, it was slightly more mixed than prior quarters. Entry-level actually representing most growth versus the mid-range and high-end. So any color on that front?

That's where we see pretty strong growth related to the SD-1 and OT, which move using the low-end unit. And at the same time, the supply chain improvements help a little bit. That's where we'll be able to ship more products in the low-end side. We still have some backlog in the middle high-end, but the low-end has some improvement by redesigning some of the products and also better supply chains right now.

Yeah, Ken's talked about this in the past, the ability to introduce the new 70F product. In the second quarter, we were a little bit hamstrung in Q2 and the beginning of Q3, even back into Q1, really, on the low end. And I think we kind of messaged a bit in our conversations over the last quarter or so that we expected low-end supply availability to really jump, if you will, in the third quarter, and we did see that. So it's really more of a supply conversation in some ways as much as it is a demand conversation. Thank you for the call, I appreciate it.

Okay, we're just bringing our next caller live, Brad Zelnick from Deutsche Bank. Brad, your line is live.

Thank you so much, and thank you for taking the questions. Ken, just a big picture question for you to start out with. You mentioned Fortinet's success is in part coming from the industry trend of vendor and product consolidation. Why is Fortinet so well positioned as a platform for consolidation, and how does this inform your product and corporate development roadmap in terms of the need for even more product breadth to compete with other platform competitors out there that keep adding additional functionality?

I think we have a few unique advantages. The first from day one, we developed the FortiASIC, which have a huge computing power increase compared to using traditional CPU. But FortiASIC also working side by side with the CPU. So that's the huge computing power advantage come from FortiASIC. It gave us more computing power for the FortiOS to run more functions, more security functions, including a lot of networking functions. So that advantage is none of our competitors have that. So that's making us keep driving the market share and also the unit shipment, I mentioned. Now we're like 43% of our market share on the unit shipment there. So that will be keeping giving us long-term growth going forward because also on the convergence of security networking, the security company in power must have a huge need to address both security networking functions there. Second is the 4D OS is well integrated together with more functions, leverage and security power. So that's also kind of a huge advantage for us compared to some other competitor, whether they have to use like different blades with different functions, or they have to load to some like a different box or even to the cloud to address some security computing power there. And then third one, we also have about 30 different products, mostly home developed. and integrate ultimately well together. So that's also what's helping drive, we call that rather security fabric, kind of called a mesh network. So that's also helping the customer to lower the management cost and total cost of ownership. I think all these three factors will keep driving Fortinet better position for the consolidation, both on the product functionality and also on different product into a single vendor platform strategy.

Ken, thank you for that, and it's clearly working very well, your strategy. Maybe, Keith, just for you, you've disclosed quite a bit of information, so much so that I have a very simple question that I just might have missed, but can you just very clearly explain for the reduction in the full year billings guidance that you've given us now the update on with these results? Thanks.

Yeah, I think you're talking about full year, fourth quarter, one of the same at this point. And I would really just point to the macro environment and what we've seen really over the last 90 days in terms of economic activity, if you will. I think when you look at how that manifests for us somewhat specifically, I think I'm getting a little more cautious in some of the forecasting of closed timing on some of the very large deals. We've been very successful over the last few years. You saw some of the numbers about enterprise penetration. with our growth in the enterprise. And the deals have actually gotten significantly larger as we've gone forward. And I think it's appropriate in that environment to be a little more cautious on what we expect the close rates to be. The business itself is very healthy. If I look at the end of the spectrum, the small enterprise part of the business, for example, it actually outgrew the other two parts of the business in the last quarter by – it took about a point of mix, I think, from the other two. So I feel good about the business, but just a little cautious about the macro environment as we go forward and how to forecast what's coming from the sales team.

It makes total sense and in line with a lot of other data points that we're all seeing out there. I guess just maybe as you think about what contributes to that, it doesn't sound like it's anything competitive, but what are the customers doing? Are they Shrinking deal sizes, are they just taking more time and sweating out their existing assets? Any other color on that would be helpful. Thanks.

Yeah, I don't think we're going to see deal sizes getting smaller, for one, because we're moving into the enterprise. If we were more established there and it was just kind of the same routine over and over, the fact that we're growing in the enterprise, and again, you saw the numbers, is going to by itself increase our average deal size. I certainly do feel that there's caution as corporate America and the rest of the world is probably going through their budgeting cycles right now and looking at what they're planning for not only the end of 2022 and 2023. I think the other aspect of that, and again, I think this is fairly consistent with other comments we've probably heard, I don't think it's a good time to really get in a position of forecasting some sort of significant budget flush in the fourth quarter. If it develops, that would be fantastic, but Yeah, I think prudence is a little bit appropriate here.

Makes total sense to me. Thank you so much for taking the questions.

Thank you.

Thank you, sir. And next up, we have Srinik Kothari. Srinik, from Robert Baird, your line is open. Thank you. Srinik Kothari. At Robert Baird, your line is open. Okay, we will move on to the next question. Please stand by. Tal Liani at Bank of America. Tal, your line is open.

Hi, I used Madeline on for a call today. Just two quick ones for me, and I apologize if this has already been mentioned since we're running between a few earnings right now. But just to be very pointed about it, you know, last quarter we heard bookings and, you know, bookings was a little bit softer than expected. This quarter, no disclosure on bookings. And again, I apologize if this was already mentioned, but just to get, you know, keep from your perspective directly, why no bookings for this quarter after a weaker quarter of bookings last quarter?

Yeah, we talked a link to this before you jumped on the call. For everybody's benefit, I'll just quickly kind of go through it. I think when we got into this conversation a year ago, we felt the backlog, which is really the driver of the bookings conversation, was something that we thought was important for investors to understand and be able to track how we're performing as a business and what they're seeing in the drivers. As we've moved forward, I think that if you fast forward a year later, I think we feel more comfortable now about some of the backlog forecasting. Earlier, we made reference to that. backlog may exit the year something closer to 400 or a little bit north of that. And so with that in mind, I think we're bringing ourselves back into what I would call industry norms where nobody else really discloses this information, but we thought it was appropriate for the first year. I would also offer one comment about backlog that's important, and we get a lot of conversations around cancellation rates. Our cancellation rate has been extremely consistent at about 4% each and every quarter.

Also, the composition of backlog is kind of different now compared to one year ago, which is one year ago, I have to say, the majority were more related to 40K. And now 40K is less than one-third of the whole backlog. And the majority of backlogs actually come from the switching AP Wi-Fi, which is also kind of a more industry problem, which is switching AP more easily. customer can change in different vendor compared to the security product. They have to design in, they have to, it's a very high switching cost. So that's where we feel the backlog sometimes unpredictable and with the majority outcome from switching AP.

Got it. Thanks so much. And just one follow-up question there too. I know you guys just mentioned having a little bit of prudence for you know, going into next year and just your guidance. I'm also just wondering on the visibility side, are you seeing less visibility, the same visibility? Can you just talk to the trends that you're seeing there in your pipeline?

I think the pipeline visibility is very good and the pipeline growth is very strong. And I think that, you know, one of the things that we did at the end of the prepared remarks was we went back to the midterm guidance numbers that we gave I think a $10 billion booking company in 2025 and $8 billion in revenue and margins of 25% or more. It basically reiterated that, and I think we're doing that, which requires a 22% CAGR from this point forward. We're doing that after looking at our pipeline, looking at the strength of our pipeline so that it makes sense to us.

Got it. Thanks so much.

Okay, getting ready for our next caller. Our next caller is Keith Backman at BMO. Keith, your line is open. Please go ahead.

Many thanks. I also had to, Keith, to start with you, I wanted to go back to the Billings commentary for Q4. Just so I know, the revenue base is essentially the same, and therefore it's a DR impact that you're guiding lower. As you mentioned that you're expecting backlog to be less than the $500 million and maybe, you know, four or four and change. Did some of that backlog, is it actually then flowing into the billings and therefore, you know, the billings guide down is even a little bit worse than it actually appears? And any other context you could draw out on where specifically that billing's weakness is, is it Europe or what have you. But if you could flesh those out, then I had a follow-up for Ken, please.

Yeah, I want to be clear. We are expecting backlog to actually increase from Q3 to Q4, not significantly, but slightly.

Okay, so therefore none of that backlog then is flowing into that billings in Q is anticipated, right?

Correct. I mean, you're always going to get some existing backlog that flows into billings, but you're going to get new backlog net-net. It's going to be an add in total to it. And I think the – and it's a good question about Europe. I don't want to gloss over that. Europe performed. You saw the revenue numbers. And while we don't disclose it, I would say the billions numbers, Europe performed very, very well in the quarter. And their pipeline remains extremely strong as we go forward. Now, we'll see as we get through and get closer to 2023. And I certainly would readily agree that there are certain tailwinds that are appropriate for Europe. But to this point, they've done very, very well.

Okay. Ken, for you then, it relates to that, very directly relates. As we think about Europe in calendar year 23, the currency, as you alluded to, is a headwind. So I was just in Europe and customers view that the prices, since you price in dollars, have actually gone up quite a bit. So is there a risk or how should we think about is there a risk of prices actually needing to come down because of the dollar-based pricing and therefore the you know significant price increase if you will felt by the europeans is there a risk that prices need to come specifically down for currency next year and or would you see any risk more broadly whether it's currency or otherwise whereby because supply and demand is coming back into balance sometime during cy23 that there is some risk rather than getting price increases that we might be in a situation where prices actually start to move lower

I think first about our price policies, really, when there's a cost increase like components and monitor, we do like take some ourselves and then some other we probably have to pass to the customer partner. But even with like a price increase, we still lead in the industry on the price performance, on the function, on the service. So that's where so far we don't see we lost steel because of pricing. And actually, we're keeping gaining market share because we have a leading price performance, especially in a lot of what we call the convergence area and also the SD1, OT, all these fast-growing areas. So it's all a price advantage compared to competitors. And also, we do see a lot of potential to drive additional service because our service charge probably average about half of our small competitor charging. Some of them offer free, some of them charge less, some of them sell as a bundle. So we do see a lot of potential growth area in the service, which also have a higher margin.

Okay. Okay. Thank you.

Thank you.

Okay. Just pulling up our next caller. And it's Greg Moskowitz from Mizuho. Greg, please go ahead. Your line is open.

Okay. Thank you for taking the questions. Keith, I know that you had experienced a bit of a pause in the first 10 days of June. With that in mind, how was linearity in a Q3 period? Were there any air pockets or anything that you would call out?

Yeah, I don't think we did see anything like we saw the first... Good question. We didn't see anything like the two-week pause or 10-day pause we saw the first part of June in the Q3. I think that it's... When we look at linearity, you can see the DSOs, and I think it's a pretty good reflection of where we're at with linearity. It has not and probably will never be a one-third, one-third, one-third business in terms of linearity. You're always going to get about 50% of your business in the final month of the quarter. But nothing really unusual about the activity there.

Okay, thanks. And just as a follow-up, we're getting – you know, quite a few questions about that billing guidance for the Q4. And, you know, you outlined earlier to, you know, in response to Brad's question, the calculus that's sort of going into, you know, the Q4 guidance and, you know, the prudence with respect to the possibility for sales cycles to be elongated. I did just want to be clear, though, on that point. As it relates to the Q3 period and perhaps even the month of October. Are you seeing any changes as it relates to the average sales cycle?

We still have a very strong pipeline, actually stronger than before. And at the same time, we built pretty healthy, strong sales capacity to meet all the demand. Keith mentioned some tenure, like we have about 50% of sales force actually has a tenure, probably not reached a tenure yet. which I believe will become more productive in the next six to 12 months, which also will help drive both the top line and bottom line.

And just so I don't confuse Ken, because I've already done that, 10 years up about 50%, 10-year people. We didn't have them given the mixed number, but it runs about 30% of the mix. So it's a significant number of people that we increased that are starting new to the organization.

And that'll make sense. I'm just wondering if there were any changes perhaps that you noticed that might have been macro-related affecting sales cycles over the past three to four months or so. If possible, it would just be very helpful to get a brief commentary on that as well. Thank you.

I just think that, as I said earlier in the conversation, as we started to see our deal size is getting larger in the enterprise, we're certainly subject to more inspection perhaps than we would be otherwise. The eight-figure deals are certainly much more inspection than the seven-figure deals were.

Okay. Makes sense. Thanks, guys. Standby for our next question. Adam Tindall at Raymond James is our next caller. Adam, your line is open. Please go ahead.

Okay. Thanks. Good afternoon. Keith, I wanted to start to appreciate that you gave a little bit of color on 2023 on services growth acceleration, obviously an exciting catalyst. I think, you know, the flip side of that is we're just kind of really unsure how to think about puts and takes to the other line item on product revenue growth. Not asking, obviously, for specific guidance, but I'm thinking about these tough comps. You know, you just had very strong growth on one of the toughest comps that you've ever experienced in Q3. Your exit rate billings guidance is coming down. I think there's worry that the cancellation rates are at 4%, but could that ultimately increase the supply chain visibility? So a lot of fear. on how bad product revenue growth could ultimately be and certainty on services revenue growth. So anything you could maybe point us to for a realistic view of how to think about puts and takes to product revenue growth in 23?

Yeah, kind of covering some old ground here. I don't mean that negatively. One, I would just, again, the fact that we reiterated the midterm guidance, which is a 22% CAGR is probably a good indicator of how we think about it. I think that investors and analysts and ourselves are trying to understand you know, the timing of when the backlog is going to reverse, you know, and actually go through the income statement and have an impact on product revenue. You know, and it's going to provide, when it does happen, I think it'll provide some elevated product revenue numbers as we look forward to it. Yeah, I don't, I had another point to that and I kind of lost my train of thought. I apologize.

Yeah, the growth driver we feel is not changed, like the convergence, like all the consolidation, also elevate like a threat environment. That's all we're keeping driving the product growth. And also the service also, I think the product revenue is usually the leading indicator of service revenue. So there's a pretty strong product revenue growth in the last two or three years. We do see the service revenue continue to improving.

Yeah. And I would come back and just talk a little bit about the cancellation rate comment that concern. Again, it has been remarkably consistent at 4%, not suggesting there's something there that would be a challenge. And certainly I think the firewall part of that, which is roughly one-third, is probably very specific to us and not really a commodity. There's other metrics that we've provided in the past, and we can certainly kind of go through them again. Over 90% to 95% of all backlog is with existing customers. It's not as if there's people coming off the street and trying to order from us because they're they're trying to double order or something like that. That's just not plausible about it. And of what's in backlog, I think, again, over 50%, and I'm looking at Peter to nod along, but he agrees with me, that it has been partially delivered. So it's unlikely they're going to cancel something. So, you know, as backlog got older, you know, did we have more concerns about it? Did we watch the aging a little bit? Yes, we did. But now we're starting to see, you know, a bit of a plateau here in terms of what the backlog increases are and certainly some easing around, too, to be on the horizon around the supply chain environment. So, While we do watch the cancellation rates very, very closely, we are not seeing indicators of concern there.

Yeah, I think one other statistic, if I'm recalling the numbers correctly, I'm going to have to look this back up, but I think the top 20 deals in backlog accounts are like 8% of backlog.

Yeah, that's what it was. Got it. Maybe I can sneak in a quick follow-up. Just to get all the fear out there, because aftermarket moves suggest there's a lot of fear. From a billings basis, you're mixing towards larger deals, which is obviously a good thing for the business, but your average contract term is flat at 29 months. A number of software companies are seeing durations decline, in particular on those large multi-year deals. How do you think about potentially controlling for this so that duration doesn't become a headwind to billings growth? Thanks.

Yeah, I think as we continue to, we've said for several years that as we continue to expand into the enterprise segment, we expect that that's going to bring with it longer-term contracts. And it has shown that. If you go back a couple of years, I think average contract rates were closer to 24 or 25 months. And you're seeing that continued pressure. And I absolutely continue to believe that as we continue to have success expanding the enterprise, and that continues to be a larger part of our business, it will continue to put a bit of a tailwind, if you will, on average contract term. I think also SB WAN has shown to clearly be a longer term contract that would come to the party. So we're not seeing that. I'm happy to see the last few quarters that we've kind of been at that 28, 29% a month and staying at that level. I was actually a little concerned that it was going to continue to grow and get into the low 30s. Thank you.

Okay, we have our last question for the session. Michael Turitz at KeyBank. Your line is open, Michael.

Thanks. So to the extent you can, can you talk about whether or not it seems realistic for backlog to continue to rise after this quarter, or is that the point you think that it starts to go down? And at a fundamental level, where do you think we are relative to demand and, if you will, a refresh cycle around data centers that may have been neglected during COVID?

I probably will not use in the refresh because I feel in the last like a couple years, it's some changing in the network security landscape. So I probably more using the convergence, especially we see the strong growth from secure SD-WAN and OT and also internal segmentation of the data center security. which security is starting to deploy into the position traditionally network security not deployed. So that's actually where most of the growth from that area. We do get into some big enterprise. They're also looking at how to do the consolidation, like whether networking security working with the other part of the infrastructure security there. And we also see a lot of strong growth for our units in the big enterprise there also. So that's probably a lot of times where they deploy into the new area. And not only the environment is a lot more fast and also a lot of like working from home remotely, but also a lot of new areas drive a lot of new deployment. So that's where probably we're not trying, we're not kind of looking at refresh, replacing some of the old network security device, but it's more in the new area we see will be driving growth for a very long time, the next five to 10 years.

And Keith on backlog?

I'm sorry, on backlog? Yeah, I mean, I think the last quarter and maybe we're looking at the fourth quarter, it the inference would be that we're at a bit of a plateau.

Still going to depend on supply there, which is still a dynamic way.

Yep.

Thanks. Okay. At this time, I would like to turn it back to Peter Salkowski, Vice President of Investor Relations, for closing remarks. Peter.

Thank you, Eric. I'd like to thank everyone for joining today's call. Fortinet will be attending investor conferences hosted by Barclays, Stiefel, and Wells Fargo during the fourth quarter. Fireshade, Cat, LabCast, Lynx will be posted on the events and presentations section of our website. If you have any follow-up questions, please send them to the presentation section. Thank you very much.

And this concludes our program. You may now disconnect. Thank you.