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spk07: Good day and thank you for standing by. Welcome to the Fortinet's first quarter 2023 earnings announcement conference 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 11 on your telephone. You will then hear an automated message advising your hand is raised. To withdraw your question, press star 11 again. Please be advised that today's conference is being recorded. I would now like to hand the conference over to Peter Salkowski. Go ahead.
spk13: Thank you, Chris. Good afternoon, everyone. This is Peter Salkowski, Senior Vice President of Finance and Investor Relations at Fortinet. I'm pleased to welcome everyone to our call to discuss Fortinet's financial results for the first quarter of 2023. 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 the call today, providing a high-level perspective on our business. Keith will interview our financial and operating results for the first quarter of 2023 before providing guidance for the second quarter of 2023 and updating the full year. We'll then open the call for questions. During the Q&A session, we do 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 will be making forward-looking statements and these forward-looking statements are subject to risks and uncertainties, which could cause actual results to differ materially from those projected. Please refer to our SEC filings, in particular the risk factors in our most recent Form 10-K and Form 10-Q, for more information. All forward-looking statements reflect our opinions only as of the date of this presentation, and we undertake no obligation and specifically disclaim any obligation to update forward-looking statements. Also, all references to financial metrics that we make today 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 that accompanies today's remarks, both of which are posted on the Investor Relations website. Ken and Keith's prepared remarks for today's earnings call will be posted on the quarterly earnings section of our Investor Relations website immediately following today's call. Lastly, all references to growth are on a year-over-year basis unless noted otherwise. I'll now turn the call over to Ken.
spk11: Thanks, Peter, and thank you to everyone for joining today's call to review our outstanding first quarter 2023 result. For the first quarter, revenue growth was 32% due to strong growth in both product and service revenue. With 35% product revenue growth, we continue to gain market share while being a leading product revenue company in the cybersecurity industry. This strong product revenue growth will help drive future service revenue growth. Quarterly service revenue grew over 30% for the first time in six years. We believe we have a significant opportunity to upsell value-added secure service to a large installed base. In the first quarter, SD-WAN and OT bookings together continued to account for over 25% of total bookings. And our goal is to become the number one in network firewall, secure SD-WAN, and OT security market over the next couple of years. Fortinet is leading the trend of network and security convergence and cybersecurity consolidation. Gartner expects that by the year 2030, the secure networking market will be larger than traditional networking. Traditional networking lacks awareness and control of content applications, users, device, and location, and is still using the same network protocol that was developed 50 years ago. Fortinet's secure networking solution has expanded from next-gen firewall to SD-WAN, SD branch, 5G, internal segmentation, ETNA, and universal SASE. and we believe the secure networking market can achieve double-digit growth annually for the foreseeable future. In today's environment, other nations are looking to consolidate their multiple security vendors and functions that are deployed across their expanding attack surface to lower their total cost of ownership and management cost by improving visibility and automating real-time threat detection and response. Fortinet's latest release of FortiOS 7.4 together with the FortiSP5 ASIC leads the industry in better integration and automation, as well as the faster acceleration while lower total cost ownership. FortiOS enables organizations to deploy the Fortinet security fabric to every edge, allowing security to dynamically scale and adapt as network evolves. Last month, we announced Universal SASE, which is supporting hybrid infrastructure and enable the same networking and security features that are available in our plans to be delivered as a service, all within a single console. Many of our service provider partners are collaborating with us on these offerings. Also, we announced an enhancement to several of our 49 security fabric solutions, including endpoint security, cloud security, SOC, and so on. As network and security continue to converge and customers looking to consolidate vendors and point product, we believe we are well positioned to achieve our 2025 building target of 10 billions by generating an annual non-gap operation margin of at least 25% for each of the next three years. Before attending the call over to Keith, I would like to thank our employees, customers, partners, suppliers worldwide for their continued support and hard work. Keith.
spk17: Thank you, Ken, and good afternoon, everyone. Let's start with the key highlights from our strong first quarter performance. Our strong first quarter results reflect a continued demand for our broad portfolio of cybersecurity and networking solutions, and the demand for consolidation and convergence that is delivered by our integrated single platform strategy. Total revenue growth of 32% was led by strong product revenue growth and service revenue growth accelerating to over 30%. Billings increased 30%, our eighth consecutive quarter of at least 30% buildings growth. Secure SD-WAN and OT bookings once again accounted for over 25% of total bookings. Our strong top-line results reflect continued customer demand across both core and enhanced platform technologies and highlights the diversification of our business model by solutions, geographies, customer segments, and industry verticals. We continue to deliver balanced growth and profitability with better-than-industry-average top-line growth and strong profitability despite the continued economic uncertainty. The first quarter operating margin of 26.5% represents the highest first quarter operating margin in our 14-year history as a publicly traded company. Free cash flow of 647 million, representing a margin of 51%, is up 23 percentage points. Both the quarterly free cash flow and free cash flow margin are Fortinet post IPO records. Last month, we hosted nearly 3,000 customers and partners at our very successful Accelerate Conference. I'd like to recap three key themes. One, the expanding firewall deployment environment. Two, convergence. And three, consolidation. So starting first, today's rapidly evolving threat landscape and connectivity demands a comprehensive approach to firewalls and network security, including a combination of hardware, virtualized software, and security services. In fact, Gardner anticipates that By 2026, more than 60% of organizations will have more than one type of firewall deployment, which will prompt adoption of hybrid mesh firewalls. Fortinet is well positioned to capitalize on this expansion of firewall deployments and form factors, as we've been delivering hybrid mesh firewalls for years on a single operating system. Second, the company was founded 20 years ago on the belief that the convergence of security and networking will become an industry standard. Gardner shares this belief, noting they expect the size of secure networking market to overtake the traditional networking market by 2030. We believe secure networking at scale works most effectively on ASIC technology. Since its inception, 4NET has been deploying, developing proprietary ASIC technologies to build application-specific solutions to support convergence, that traditional CPU-based solutions are less efficient at supporting both networking and security. Third, vendor and product functionality consolidation strategies continue to become more commonplace. Looking to Gartner here again, they note 75% of organizations are pursuing a cybersecurity vendor consolidation strategy in 2022, up from 29% in 2020. Our integrated 40OS platform allows customers to converge networking functionality with security capabilities while consolidating cybersecurity products and functionality. With 40ASIC's significant computing power advantage, 40OS can consolidate more security functions and solutions while maintaining our performance and cost advantage. Specifically, 40OS supports many security applications, including Network Firewall, SD-WAN, SASB, 5G, Wi-Fi security, ZTNA, VPN, and SSL, with a variety of use cases for each security application. For example, firewall use cases include data center, branches, edges, virtual, cloud native, micro segmentation, both east-west and north-south, and firewall as a service. Our convergence and consolidation strategy provides security across our customers' entire digital infrastructure, while lowering their operating costs. All right, now let's take a closer look at the first quarter. Billings grew 30% to $1.5 billion, driven by enhanced platform technology solutions. In terms of industry verticals, government and financial services topped the list as a percentage of total billings, with financial services up over 40%. Construction, media, and utilities were all up at least 50%. Those growths benefited from better than expected backlog contribution. While the backlog cancellation rate increased quarter over quarter, it was lower than we had forecasted in our model. We continue to believe there's an elevated cancellation risk in future periods for networking equipment backlog. Bookings grew double digits in the quarter, off a challenging comparison of 50% growth in the first quarter of last year. We continue to see success with our strategy to expand further into the large enterprise segment with a number of deals over $1 million increasing 38% to 124 deals, and buildings on these deals increasing 50%. One of these deals was an eight-figure expansion and upsell opportunity at a Fortune 50 retailer. The retailer was looking to replace their firewall point solutions with a more holistic cybersecurity solution. After purchasing 4D Manager and 4D Analyzer in the fourth quarter of last year, this customer selected 48 VMs for a very competitive effort, a very competitive process for their 2,000 store locations as part of our new 40Flex program. 40Flex is a new points-based consumption program supporting hybrid mesh firewall deployments as well as a variety of other security solutions. The customer selected Fortinet due to the substantial value offered by our unified platform and the significant technical requirements. In the first quarter, we added approximately 6,100 new logos reflecting the support of our channel partners through their investments and the investments we've made in them. Average contract term was flat year-over-year at 27 months and down one month quarter-over-quarter. Turning now to revenue, total revenue grew 32% to $1.26 billion, driven by strong demand for core and enhanced platform technologies, increasing 23% and 50% respectively. Product revenue of $501 million increased 35%, despite the very difficult comparison to last year's first quarter of 54%, with its very strong contribution from acquisitions. Product revenue growth was driven by strong growth in enhanced platform technologies, improving supply chain dynamics, and our earlier pricing actions. Service revenue was up over 30% to $762 million. the highest growth rate in services since 2016. The average number of days between when the customer purchases and subsequently activates a security service contract declined slightly sequentially and remained elevated on a year-over-year basis. Service revenue growth was closely aligned with our short-term deferred revenue growth rate in recent periods. Short-term deferred revenue growth was over 30% for the fourth consecutive quarter. Total gross margin of 76.3% was up 190 basis points, including a 440 basis point increase in product gross margin to 61.8%. Product gross margin benefited from earlier pricing actions, improved discounting, and easing cost pressures. Service gross margin of 85.9% picked up 70 basis points as price increases offset increased investments in data centers and points of presence, or POPs. Operating margin of 26.5% was up 450 basis points due to the strong gross margin performance, a foreign exchange benefit, and revenue growth that was 10 points higher than our 22% headcount growth. As previously noted, 26.5% is our highest ever first quarter operating margin as a public company. Looking at the statement of cash flow, summarized on slides 7 and 8, Free cash flow was a quarterly Fortinet record at $647 million and benefited from elevated receivables in the fourth quarter of last year and the subsequent cash collections, as well as the record-setting operating margin and the timing of CapEx projects. Adjusted free cash flow, which includes the real estate investments, was $662 million, representing a 52% adjusted free cash margin and our highest margin since our 2009 IPO. We've come to expect some quarterly variances in our free cash flow results, with the first quarter often stronger due to the seasonally strong fourth quarter billings. Capital expenditures were $30 million, including $15 million of real estate investments. This was lower than expected due to the timing of real estate activities. Cash taxes were $21 million. The Board increased the company's share repurchase authorization by $1 billion, and the total available share buyback authorization is now $1.5 billion, for repurchases through February 2024. Looking forward, we are excited about the growth drivers that we've discussed previously, as well as our new single-vendor Universal SASE offering. Our Universal SASE offering delivers a comprehensive solution that extends the convergence of networking and security from the edge to remote users while helping teams drive operational efficiency and reducing complexity and costs by consolidating vendors. In fact, Gartner predicts that by 2025, one-third of new SASE deployments will be based on a single-vendor SASE offering, up from 10% in 2022. As we bring universal SASE to market, we expect to make various investments, including increasing our POPs. Our guidance reflects the impact of these investments to both our gross margin and capital expenditure estimates. Moving to guidance. I'd like to review our outlook for the second quarter and full year summarized in slides 10 and 11, which is subject to the disclaimers regarding forward-looking information that Peter provided at the beginning of the call. For the second quarter, we expect billings in the range of $1,560,000,000 to $1,600,000,000, which at the midpoint represents growth of 21%. Revenue in the range of $1,280,000,000 to $1,320,000,000, which at the midpoint represents growth of 26%. Non-GAAP gross margin of 75.5% to 76.5%. Non-GAAP operating margin of 24.5% to 25.5%. Non-GAAP earnings per share of 33 cents to 35 cents, which assumes a share count of between 790 and 800 million. Capital expenditures of 80 to 110 million. a non-GAAP tax rate of 17%. Cash taxes are $35 million, which is lower than our prior expectation as the deadline for certain tax payments has been extended to the fourth quarter. The second quarter, guys, assumes backlog decreases during the quarter. For the full year, we expect buildings in the range of $6,750,000 to $6,810,000, which at the midpoint represents growth of 21%. This guidance assumes a low single-digit impact of buildings growth from backlog. Revenue in the range of $5,425,000 to $5,485,000, which at the midpoint represents growth of 23.5%. Service revenue in the range of $3,370,000 to $3,400,000, which at the midpoint represents growth of 28%. The service revenue guidance implies product revenue growth of 16%. Non-GAAP gross margin is 75% to 76%. Non-GAAP operating margin of 25% to 26%. Non-GAAP earnings per share of $1.44 to $1.48, which assumes a share counted between 795 and 805 million. Capital expenditures of 400 to 450 million due to the continued cloud data center and facilities investments. Non-GAAP tax rate of 17%. Cash taxes of 390 million. with approximately $300 million in the fourth quarter. The full-year estimates assume backlog returns to historical levels later this year. As we wrap up the prepared remarks, maybe one additional observation. Over many years, the Fortinet team and its partners have offered very solid and consistent level execution across a wide range of economic cycles and other challenges. Like many others, we see a level of economic uncertainty in front of us, And we look forward to this possible challenge in delivering on our goals. I'll now hand the call back over to Peter to begin the Q&A.
spk13: Thank you. 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. Chris, please open the call for questions.
spk07: Thank you. At this time, we'll conduct the question and answer session. As a reminder, to ask a question, you'll need to press star 1-1 on your telephone and wait for your name to be announced. To withdraw your question, press star 11 again. Please stand by while we compile the Q&A roster.
spk06: Our first question comes from Brian Essex of JP Morgan.
spk15: Your line is open. Hi, good afternoon. Thank you for taking the question and congrats on a nice quarter, particularly in a tough macro. Steve, for you, nice acceleration in services revenue this quarter. And I know Ken talked about more effectively selling or selling value-added services, secure services into your install base. How much was due to that, you know, better attach rate of secure services versus changes in registration policy or pricing increases in the quarter?
spk17: Yeah, great question, Brian. And I think when we peeled back the onion and looked back, we saw in FortiGuard, which is the security services part of the business, and you'll see this in our SEC filings next week, growth was 35% to FortiGuard. So we started looking more deeply at that. And to Ken's point, what we saw there were areas like SaaS products and offerings that are attached to existing customers, certain cloud offerings, what we call pay-as-you-go, if you will, are attached to it as well. And I would describe those as being a significant driver to the growth. I think the price benefits would probably take the number two slot, and then the number three slot would be some changes in the registration behavior. By that I mean customers did register a little bit faster in the first quarter, but that registration policy change that we implemented in the first quarter, I would specifically call out as not really having an impact in the first quarter, nor did we really expect one. So kind of in order, I think it was. selling into the install base, price increases, and then some wide improvements in the registration behavior.
spk11: Yeah, also with the new 4DOS 7.4, they started launching. We started to have a more function, which also enabled much more new service going forward for both the current customer installation base and also for new customers.
spk15: Got it. That's helpful. Maybe as a follow-up piece, I think you commented on lower than expected cancellation rate. I know the question will be asked, impact on billings from backlog training and what some of your assumptions are, particularly given what you see in the macro. I know you talked about you expect to be at normalized rates for backlog by the end of the year, but maybe if you're going to contextualize or quantify that to the extent that you're able to.
spk17: Yeah, I think in the guidance, particularly as we look at the full year, it's kind of difficult to figure out exactly which quarter some of that backlog is going to end up in or be canceled. But for the full year, I think we talked about low single-digit growth that would be coming from the backlog. I do think that the risk to cancellations increases as the year progresses. And by that, I mean if a customer has only been in backlog for a week or a month or something like that, there seems somewhat less probability that they're going to cancel. But the longer it takes to deliver on that backlog, I think the cancellation risk continues to increase.
spk11: Also, a point that you mentioned earlier, go back normal end of year. We see it later this year, could be middle, could be towards the end. But in Q1, I say the operation team did a great job to reduce the backlog, which also helping secure more customer and lower some cancellation rate.
spk15: Got it, very helpful. Thank you both very much.
spk07: Thank you. One moment for the next question. This question comes from the line of Gabriella Borges with Goldman Sachs. Your line is open.
spk10: Good afternoon. Thank you. I have a follow-up question on forecasting, which is we've heard so much noise in the industry around supply chain and COVID-catalyzed product cycles. How do you all think about true demand and potentially plan around the risk of demand going faster than expected, given you've had a very strong couple of years? Thank you.
spk11: I think probably some of that more refer to the traditional network security, secure some enterprise, deployment enterprise. But we do see that our solution has a much broader use case and also expand to much bigger market opportunities than the traditional enterprise firewall and also the SD-WAN OT. It's also see very strong growth continue to helping drive both the new customer and also expanding the current existing customer. Also in the SMB space, it's a relatively green field. We also see pretty healthy, faster growth, probably even faster than the traditional enterprise, which is more replacement. I think all this is contributing to pretty healthy growth. you can say, double-digit growth in the future for the whole security space.
spk10: Yeah, that makes sense. Thank you. And, Ken, the follow-up is for you, which is, as you start to execute more on the convergence of selling into the networking budget or the convergence of networking plus security, when you look at the classic networking competitives, How do you think about the barrier or the limitation for classic networking vendors to get more into security and become more competitive in the convergence of the time?
spk11: I would say from the product architecture, it's very different because security needs much more computing power and to handle a lot of unstructured data. which the traditional networking company probably will, based on some structured data, handle some fixed next protocol, and much less computing power needed to process data compared to the network security. So that's where, and also we would have to implement a function, and new functions come up every year in the software first, and then keeping enhancing and improving the performance leverage ASIC. That's also, we don't see networking company doing some of that. They probably, they'd be slow on where to come up with a new function for the security space. All kind of have a different architecture to really supporting the secure computing needed for network security. So far, we have not seen traditional networking company really come close. They did some acquisition, but so far, I don't see they really come up too much since to meet a new demand from customer, both on the function and also on the surveys on the infrastructure change.
spk10: Thanks for the detail. Congrats, Makota.
spk07: Thank you. Thank you. One moment for the next question.
spk06: The next question comes from the line of Fatima Bulani of Citi.
spk07: Your line is open.
spk08: Thank you. Good afternoon. I appreciate you taking my questions. Ken, just a technology vision question for you. You are very, and the team is very bullish on the SASB opportunity that was very apparent at the Accelerate conference as well. But I'm curious as to why you're taking the effort to build out data centers and points of presence to deliver your universal SASE strategy versus maybe some of your peers and competitors who are maybe relying on third-party providers and hyperscalers. And then I have a quick follow-up for Keith, please.
spk11: First of all, SASE kind of vision is a bit different than some of our competitors. we do believe need to be universal, need to be more broadly deployed, and also more leverage a lot of service provider infrastructure. It's kind of a hybrid environment instead of a cloud-only SASE solution. And we do keep expanding some of our POP because definitely there's some user, like whether depending on working from home or some other cloud SASE to secure some of their traffic here, But on the other side, there's a huge base of customers need to use SASE, our kind of service model, leverageable service provider, all their current infrastructure, and even on-site appliance. And so that's where, at a certain point, we also see our 40 switch and 40 APs are kind of our agent for helping forward the traffic for the 40 gate to process all this SASE traffic there. So that's the reason we kind of put SASE in a single OS, both on the networking side of the function, like SD-WAN, 5G, all the other, plus the security, like a CASB, DLP, all these 5W servers, all these things. So that's where we have a more integrated, more broadly distributed, and leverage whatever the hybrid infrastructure SASE solution is there. That's also the reason we continue to build some of the POP. It's a little bit different than some other leveraged cloud provider because we do see the cloud provider potentially also can be the service provider to offer SASE. And also from the how I point of view, even have a little bit more investment from the beginning to build some POP ourselves, but long-term will be more profit model. So we'll have a better margin. So we will take some time to make sure we build a healthy ecosystem, both with our partners and also with the investment for long-term benefit.
spk08: I appreciate that detail, Ken. Keith, just quickly for you, kind of a tactical question on the billings outlook. You're raising the full year by less than half of the bid and raise when I think about the first half. And so maybe from a bottom-up perspective, can you walk us through what's sort of underpinning that conservatism? I can appreciate the macroist jittery, but if you can kind of give us some more tangible considerations you're thinking about in terms of a bottom-up perspective on getting to that billing guide for the full year. Thank you.
spk17: Yeah, I would say one just kind of as a general thought, I think raising it to some extent, I think probably gives you a little bit of a of a message that we feel good about our strategy and the execution level that we can bring to the market. But more specifically and more tactically, as we look through the second half of the year, there's probably a little more rigor and effort, if you will, in trying to look at what we see coming in the second half of the year. And I would give you probably two headlines that we're looking at. One is, We're still very, very pleased with the pipeline. The pipeline continues to be well above anything that we're talking about growth rates for the company for the full year. But I think the nuance that, and maybe it's not even a nuance really, that's coming to play now is more about close rates. It's not just as simple as taking your pipeline and assuming you're going to have close rates that were at the same level they were in prior periods. And that, when we use the term close rate, it's not a suggestion that deals are getting lost, but this continual cycle that we seem to be in where some of the larger enterprise deals in particular are taking longer, they're pushing out a lot of pushes. It's not that there's been an increase in losses, but the continual push. And so with that in mind, I take a fair amount of attention to looking at the full year guidance on what we really think our close rates may be for the second half of this year.
spk13: Thank you. Uh-huh.
spk06: Thank you. One moment for the next question. This question comes from the line of Saket Kalia of Barclays.
spk07: Your line is open.
spk02: Okay, great. Hey, good afternoon, everyone. Thanks for taking my questions here. Ken, maybe just to start with you, great to see Fortinet sell the whole breadth of the platform, particularly within the enterprise. Could you just maybe talk about anything that you can do to make it easier for customers to consolidate spending with Fortinet? You know, whether that's an enterprise license agreement or any other thing that sort of makes it easier to, you know, to combine, you know, consolidate those vendors, which was a theme I think was talked about earlier.
spk11: We definitely see some healthy growth of our enterprise agreement, and also we're working closely with our a channel partner with a service provider, also leverage their connection, their resource, build a healthy ecosystem to grow together. But I also see from an enterprise level, they also see the benefit of consolidation definitely. And also not just consolidate some of the created product, but also expand the infrastructure, go beyond the traditional uh, network security. Uh, so that's also, we see pretty healthy growth, uh, mega Q and we do see that we could enhance, uh, uh, enhance technology side also has pretty healthy growth. Uh, yeah, the Salesforce also, you can see the number of, uh, 1 million deal, uh, both on the number and also on the dollar wise has a pretty healthy growth, uh, continue to accelerate and grow beyond the total building growth. Uh, so that's, that's a pretty healthy, trend we see going forward to helping customer consolidate.
spk17: Yeah, and Saka, maybe just to go a little deeper on what Ken's talking about there, and I'll give you maybe four quick examples. So enterprise agreements, something that we've been doing now for probably a couple of years. We track those in some ways as a different line of business in terms of the growth rates. And particularly as we've moved into the enterprise, I think it's been very important to be there, and we've been very successful with it. I think another illustration of trying to make it easier for customers was the example of the large retailer we gave on the call today. And we talked about the points program, which is an easier way, I think, sometimes for them to get on board and consume more of the products. And I think also then when we sell, making sure that our salespeople are well-trained on the value proposition that we're offering, not just on the cost of the appliance or the throughput or the performance, but also what it means to the customer's management costs and overhead costs as well. So I think those types of things are all going into play here to support what Ken is talking about, about making it easier for customers to consume our products.
spk02: Got it. That's super helpful. Keith, maybe for my follow-up for you, great to see that 30% growth and acceleration in services revenue. Maybe the question is, how do you think about what portion of your existing subscription base hasn't seen that cumulative impact of the price increases you've done yet, right? Like clearly the price increases on product have been fully baked, but how much of the base or maybe how long will it take for the subscription base to fully realize that pricing as well?
spk17: Yeah, great question. And I think it didn't really look at the numbers closely this quarter, but the last quarter, a couple of things to keep in mind, you know, average contract term, call it 27 months. You know, if all the contracts are 27 months, you could do that math, but they're not, you know, some are one and some are three year contracts. in terms of the renewals that are coming through. So probably one in five-year contracts. Sorry, Peter, thank you for that. So it does have a long tail. And, again, I refer you back to how many quarters or how many years that we talked about seeing the uplift that came when we converted to 24 by 7 support from 8 by 5. You know, that was something that continued to provide a benefit for several years. I think the tail gets smaller, obviously, as you go further out. I think the majority of the existing contracts, more than 50%, are under the new pricing.
spk02: Very helpful. Thanks, guys.
spk07: And thank you. One moment for the next question. The next question comes from the line of Shawl Isle of TD Cowan. Your line is open.
spk00: Thank you. Good afternoon. Congrats on results and guidance in a tough macro. Keith, maybe starting with you, can you comment, can you provide us with some color about the financial vertical performance this quarter?
spk17: Yeah, well, financial services have always been one of our, I shouldn't say always, but for a long time they've been the top three. And it can be a bit feast or famine there with some very large deals in the quarter. But I don't think there was anything that was number two in this particular quarter. Thank you, Peter. I don't think there were any really large deals that drove that number. I think it was we saw growth and success not only in the U.S., but also internationally, particularly in Europe. And so I think it was a strong quarter for us in that area.
spk00: Got it. Got it. From a product mix perspective, so the entry level performed the best versus the high end. Is that just a mix or a macro reflection? And also, did you have any eight-digit wins this quarter?
spk17: So we talked about – yes, we did. Okay. I think we talked about one in the script a moment ago, and I think we commented it was an eight-figure deal, if I'm not mistaken, right, without giving a specific number. Yeah. And I don't recall if there was a second eight-figure deal. There was a second eight-figure deal. Okay.
spk11: Yeah, also our SMB are pretty healthy growth. Like I said, SMB is a more green field for the network security. We do see more and more SMB need a network security to protect their business, especially if it comes from some other ransomware attacks. On enterprise, because it's kind of more replacement, and also a lot of enterprise kind of maybe the big armaments, you know, and refresh some of the hardware, more dependent on the service. So that impacts some of the high end. And also the other benefit for some of the low and middle range is really most IC1 and some of the O2 deployment may be more towards the low and middle range.
spk00: Got it. Thank you. Appreciate it. Well done.
spk07: Thank you. Thank you. One moment for the next question. This question comes from Rob Owens of Piper Sandler. Your line is open.
spk04: Thank you very much, and good afternoon. Thanks for taking my question. I wanted to start around OPEX or the Corollary Operating Margin. A very strong first quarter here. I think you mentioned it was the strongest Q1 that you've had since you're public. If I go back through results since you've been public, Q1 has never really been the high watermark from an operating margin standpoint. So walk me through your thought process As the rest of this year plays out, was there some aberration in Q1 that really helped drive that or just a lot of conservatism as we look ahead?
spk17: Yeah, I think that we called out three things and maybe focusing on two. One, we had a very strong gross margin in the quarter, and I'll elaborate on that in a moment. And then also FX, you know, continues to provide a tailwind. More commentary about the gross margin, particularly the product gross margin, as we move through, you know, the supply chain challenges and then into inflation, et cetera, over the last couple of years. I think we've talked publicly that our goal was to try and keep the product gross margin around 61% or so. The fourth quarter came in obviously very low. We did not anticipate that we'd be able to time our price increases and the cost increases perfectly, so they went through the income statement in the same quarter, so to speak. And with that, I think you saw a little bit of pressure in the fourth quarter, and then you saw it kind of revert in the first quarter. I think longer term, we also look at product gross margin as an opportunity sometimes for us to continue to invest in growth. And I think we saw the first quarter gross margin certainly well above that band that I just talked about. And with that in mind, as we start to see some of the costs moving out of the equation and we introduce new products, I think we'll be looking at that in terms of is there an opportunity there to make certain investments in growth while maintaining the margin commitments that we've talked about.
spk04: Great. And then as a follow-up, did want to touch on the OT business and the strength you're seeing there. Can you talk a little bit from a go-to-market standpoint and some of the channel programs? Because it does seem like there's some new large channel partners out there that are very excited about the opportunity. Thanks.
spk17: Yeah, I think OT, we do look at, I mean, you're always trying to organize your sales force around verticals, geographies, or what have you. And I think when we started to see the opportunity in OT several years ago, Patrice and Ken made a decision to start separating that out and having really a separate sales function and some people that specialize in that. I do think that we probably got some first mover advantages by doing that, particularly as we look at Europe and then quickly followed thereafter by the U.S. And yes, there are some large names that are in that space that are providing opportunities not security technology, but technologies in the OT space that have been very receptive, if you will, to conversations and opportunities to meet with us.
spk05: Thank you very much.
spk06: One moment for our next question. The next question comes from Adam Borg of Stifle.
spk07: Your line is open.
spk14: Awesome. Thanks so much for taking the questions. Just for Ken or Keith, obviously, it's great to see a strong collection and the record-free cash flow. And you also talked about contract terms being consistent year-on-year. I was just curious, though, just given the tougher macro, are you seeing any pushback by customers around willingness to pay up front? And then I have a follow-up.
spk17: Yeah, well, first of all, I want to revel in the $600 million free cash flow in which I'll be doing it for several more quarters. But I kind of let people know that a lot of the things fell our way in the quarter. There's always the conversation in part of the sales cycle, if you will. The customer's a lot of one-year, three-year, five-year deal. And certainly in an environment where interest rates have gone up, I think there's a lot more, many more conversations that exist around the payment terms and things like that. You know, I do believe that, you know, just as we just talked about in the second quarter of 2020 when COVID hit, we have a very strong balance sheet. We obviously have very strong margins, you know, and it's appropriate for us to look at that as opportunities to leverage our balance sheet. Sometimes that may be in the form of extended payment terms or what have you, and our income statement in the form of, you know, how we want to go about discounting and supporting growth. So I think that, again, the strength that we've had, we have the ability to do those things. If the question is around what are we seeing from some of the enterprise customers, and Ken's seeing a lot of this as well, do we see deals that go from five years to three years? Sure. Is it more than we've seen in the past? I kind of look back at the contract term data point that we give and say maybe, but not a lot kind of a thing. And on payment terms, you know, the channel has always offered a financing function. I think they prefer to provide the financing function. And I think we provide support to the financing function to the channel by making capital available to them through payment terms.
spk14: That's really helpful. And maybe just as a quick follow-up, you know, headcount was up a little bit over 600 people, quarter over quarter, up over 21.5% year-on-year. Just curious how we're thinking about headcount growth either in 2Q or later this year. Again, just give the macro. Thanks again.
spk11: Yeah, we are, overall, we look at both high-con and high-con costs, probably the same pace, company growth, the top line, and also try to, at the same time, try to improve some efficiency there. So we're not looking for high-con growth above the top line. Even we feel there's still quite some area we also need to do some more investment, long-term investment. But companies, so far, we feel we have a pretty healthy finance model. And this also could be the opportunity to also gain in some market share.
spk14: Great. Thanks again.
spk07: Thank you. Thank you. As a reminder, to ask a question, please press star 1 1 on your telephone and wait until your name is announced. Please stand by for the next question.
spk06: This question comes from Itai Kidron from Oppenheimer and Company.
spk07: Your line is open.
spk16: Thanks, guys, and nice results. My first question, I guess, is on the U.S. enterprise. So not U.S. in general, but just the enterprise vertical, clearly one of the most important growth opportunities for you long term. Can you talk about progress over there, win rates, displacements, and is the macro making things easier or more difficult for you specifically in the U.S.? ?
spk11: First, we continue to invest in the U.S. enterprise. We also see the huge growth potential for us because we have relatively small market share. And with all the strong product technology we have. On the other side, the big environment definitely slowed down some of the enterprise making certain decisions, whether to refresh or something like that. But on the other side, our solution has a better, lower total cost ownership and also can expand beyond the traditional network security and also helping customers to consolidate. So I think all this combined together, we do see the U.S. enterprise definitely is a strong growing area for us.
spk16: Okay, thanks. And then maybe follow up on the competitive side then, Ken, maybe. You can talk about what have you seen out of your competitors here in the U.S., any kind of abnormal activity from discounting or otherwise?
spk11: I think in the slowdown of some of the big environment, definitely the competitors starting to move more aggressive, whether on some discount or offer some free some percentage of free service. But from our angle, we see we have much better product position, much broad infrastructure coverage, and better service. And also both on the performance angle, the product definitely has performed much better for the same function, same cost, and same time. Our service also has much more value and cost lower than competitors. So for us, we have not experienced price pressure or discount pressure. It's more about how we can increase the coverage, increase the lead gen pipeline, and also to meet the customer need in this big environment change. Thank you.
spk17: Thank you. I would think that what Ken talks about, I think, is fantastic. I think keep in mind, you know, we have a very, as we kind of talked about, a very diverse customer base, if you will, between being international, between being very large, mid, small, and MSSPs, et cetera. So I don't want to put a policy in place that covers every geography and it covers every customer size. And I think what you're really talking about here is something that, for us, represents 15% of our business, maybe just a little bit less. And because it's at that size, it's something that we can really more, I think, target our responses to as we get deeper into the selling function, as opposed to some broad announcement that we're going to give away services for two years or something like that.
spk07: Very good. Thank you. Thank you. One moment for the next question.
spk06: This question comes from the line of Angie Song with Morgan Stanley.
spk07: Your line is open.
spk09: Hi, thank you guys so much for taking my question. I'm on for Hamza Fadarwala at Morgan Stanley. So could you just share a little bit more about your current interest around the SASE or current customer interest around the SASE product and What are some of the responses around this so far?
spk11: It's a pretty strong growth, and also we're working with a lot of our service providers, both on the infrastructure side or security service side, and offer the SASE because we do believe SASE should be an ecosystem with a lot of players instead of just a vendor offer their own SASE because a lot of our I'd say probably most of the customers, they prefer some of their data being processed, controlled themselves, whether some private SASE or some data sovereignty keeping the data within certain geo. So that's where we see the SASE approach, we call universal SASE, give the customer flexibility to offer both cloud-based or on-premise-based or kind of leverage service-provided infrastructure will be more benefit for the whole industry long term. So that's where even sometimes we kind of take a little bit more time to develop all the SASE functions in a single OS, but that's making it more easy for the customer, for the service provider to deploy SASE to fit their need and their environment. So we see a very, very healthy pipeline and a strong growth, kind of accelerated growth. And that's also based on kind of a more healthy margin kind of model instead of losing money, all of our growth. So we want to maintain that kind of model and also working closely with our partner to offer kind of a chassis to gather to the customer.
spk09: Got it. Thank you. And just one more around profitability. So how are you guys thinking about... growth slows down over the next few years, and where do we see that margin leverage?
spk13: Angie, can you repeat that? You cut out in the beginning of that question.
spk09: Yeah, no worries. So the question is around profitability, and I was just wondering what you guys are thinking about upside to profitability as growth slows down, and where should we expect to see that margin leverage?
spk11: We see the mid-term model will be 10 billion building by 2025 with a non-capable margin at least 25% for each year in the next three years.
spk09: Got it. Thank you.
spk17: Yeah, I think the – one thing, Angie, and I think Hans was about this before as well, keep in mind, you know, two-thirds of the business roughly is service revenue. And that's producing a gross margin that's in the mid-80s. And those are longer-term contracts. So I think the business model is such that we have time to react if there was something really dramatic that happened in the industry. But for that to happen, I think you'd probably have to see some sort of shift in the behavior of the bad actors, the nation states, the organized crime groups, et cetera, and we don't see that that's on the landscape.
spk09: Great, thank you so much.
spk07: Thank you. Please stand by for the next question.
spk06: This next question comes from the line of Tal Liani of Bank of America.
spk07: Your line is open.
spk03: Hey, guys. What we've seen with good companies in the last two quarters is that they make great numbers, but When you look at the composition, new customers are slowing down and sales to existing customers are going up, and we've seen it through multiple companies in the space. So the question is whether you can provide us with some data on sales to existing customers versus new customers, and how is the current environment on customer acquisition, on new customer acquisition? Thanks.
spk17: Yeah, so as a reminder, Tal, good to hear from you again. If you think of the business being extremely diversified, whether that's geographically or by customer segments, one-third small, one-third mid, one-third large. We specifically called out in the script that we added over 6,000 new logos in the quarter. That's probably a growth rate that's easily into double digits. New logos take a while to really produce revenue for us. It tends to be less than 10% of total revenue from the new logo so it creates the opportunity to continue to sell into them you know kind of Kent's comment a moment ago to your question here you know do we see large enterprises in the US still moving forward robustly with all their various digital transformation projects I think that the word on the street is you know that that slowed down a little bit and in that environment I do think that incumbents sometimes have an advantage but also A cost of performance argument and debate is something that you see customers perhaps more receptive to in the current macro environment.
spk03: In the current macro environment, is the duration of contracts going down?
spk17: Again, it was flat year over year, down one month, quarter over quarter. Got it. Okay. Thanks. Which, as somebody reminds me in the room very politely, every first quarter is down one month. Got it.
spk13: Sequentially.
spk18: thank you one moment for the next question this question comes from the line of andrew nowinski of wells fargo your line is open okay thank you and congrats on the nice quarter um so i wanted to ask about uh your sassy offering as well uh you talked at the accelerate conference about I think having 8 to 10 new use cases driving demand for the firewall, but I'm wondering if SASE could be one of those use cases as well, meaning is the firewall appliance a critical component of your SASE offering?
spk11: Yes, SASE definitely is one of the use cases, especially the universal SASE or sometimes they call the private SASE. For some customer or some service provider, they want to have a more control of their data. And so that's what we see is both SASE, like the service model, customer benefit and service provider has a big value added to that one, but at the same time, gave them the flexibility of whether for some traffic to the cloud or to the pub or have a process on premise and by the appliance. So that's what we see, the huge benefit of universal SASE solution. which is very different than some other SASE player. And a lot of customers and partners are very interested in this universal SASE approach.
spk18: Thanks, Ken. And then maybe a question for Keith, just as it relates to your CapEx. You talked about a component of that being used to build out more POPs to support the SASE offering. But is that something, like how should we think about CapEx and that investment beyond 2023 as you continue building out your network?
spk17: Ken and I are smiling at each other. We've had this conversation. I think I've been here for nine years as of this week. One thing I've come to appreciate is that Ken behaves like a long-term investor. With that in mind, owning critical real estate assets tends to have a better payback than leasing them over an extended period of time, whether that's in R&D facilities, whether that's in manufacturing or warehouse facilities, or that as we move into the SaaS market, as well as other cloud offerings. It's not just investments in SASE, if you will, but it's also investments in larger data centers in order to deliver various cloud-based services and solutions. And I think you've heard us talk about that in the last couple of earnings calls and the guys of data centers having an impact on margins for services and CapEx spending. So I don't think there should be a surprise there, but I think it is an indication of our looking to expand more fully into some of these other markets.
spk18: Got it. Thank you.
spk07: And thank you.
spk06: One moment for our final question.
spk07: Our last question comes from the line of Srinik Kothari from Baird. Your line is open.
spk01: Hey, thanks for taking my question. So for Ken or Keith, I think, Keith, you mentioned about the financial services up over 40%, which is surprisingly strong and contrary to what we are hearing from your peers and competitors. So can you expand a bit upon the underlying drivers? I know you touched upon it, but I just wanted to expand on the geographical diversity or is it increased impetus for vendor consolidation that is benefiting you guys in that vertical? If you can just elaborate and then I have a quick follow-up.
spk17: I would say it's all of the above. It's happening geographically. I think it's happening with customers that we took down earlier that are expanding with us with additional firewalls and additional services as well. I think the market, if you will, financial services, if you step back and look at what's happening there, specifically the firewalls over the last several years, there's probably two legacy vendors there that when their contracts are up for renewal, And we've talked about this for a long period of time. Now, they're exposed. And it creates an opportunity to come in for a competitive displacement. And I think that some of the other comments or questions today is, you know, is it more difficult in this environment for competitive displacement? I mean, sure. You've got to work a lot harder to make it happen. You've got to make your value proposition more well-known. But I think, again, I think it's expansion. I think it's opportunity to displace incumbents. And I don't think it's specific to any one particular geography.
spk11: Also, from technology angle, we have two huge advantages. One is the for the internal segmentation of security data center. So because the ASIC advantage we have, we can deploy in a very high-speed environment, which a lot of our finance service providers, they do need to secure their kind of internal segmentation there. The other part, really, some of our finance service also starting to support work from home, working from remotely, which we also have a very super solution with our ASIC-based small appliance. I can support in this kind of our broad infrastructure approach combined with that, like I see one or the other 5G, 4G network and security together. So that's given us huge advantage from the product angle.
spk01: Got it, got it. Thanks a lot, Ken, Keith. Just a quick follow-up, and you guys, of course, touched upon the expansion opportunity and the form factors. Of course, your peers and colleagues have spoken about unit expansion pressures and how the product unit growth is kind of normalizing. But just wondering, given that you guys give examples of this eight-figure expansion and upsell opportunity, replacing firewall with a holistic solution, can you talk about expansion drivers broadly? Are you seeing mostly upsell and expansion in form factors versus the units? Just wanted to get some clarification here.
spk11: Yeah, probably both. Yeah, we do see the expanding of both the unit and also upsell, cross-sell of the entire 40 security fabric, which has a 53 product. So that's where both our internal sales force and also partners do a lot of upsell, cross-sell for the whole fabric. And at the same time, because we combine networking security and more function together, I have a multi-ploy case, which also the union chairman also started keeping growth quite nicely.
spk01: Got it. Thank you a lot, Ken. I appreciate it. Thank you.
spk07: Thank you. That concludes the Q&A segment. I'll now turn it back over to Peter Sochowski for closing remarks.
spk13: Thank you, Chris. Apologies to the seven people we left in the queue. I'd like to thank everyone for joining today's call. Fortinet will be attending investor conferences hosted by J.B. Morgan and Bank of America during the second quarter. Fire State Chat webcast links will be posted on the event and presentation section of the Fortinet Investor Relations website. If you have any questions, please feel free to contact me. Have a great rest of your day. Thank you.
spk07: And thank you for your participation in today's conference. This does conclude the program. You may now disconnect.
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