Fortinet, Inc.

Good day, and thank you for standing by. Welcome to the Fortinet Q2 23 earnings call. At this time, all participants are in a listen-only mode. After the speaker's presentation, there will be a question and answer session. To ask a question during the session, you will need to press star 11 on your telephone. You'll then hear an automated message advising your hand is raised. To withdraw your question, please press star 11 again. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Peter Salkowski, Senior Vice President of Finance.

Thank you, Therese. Good afternoon, everyone. This is Pete Salkowski, Senior Vice President of Finance and Investor Relations at Fortinet. I am pleased to welcome everyone to our call to discuss Fortinet's financial results for the second 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 the Investor Relations website. Ken will begin our call today by providing a high-level perspective of our business, key to our financial and operating results for the second quarter of 2023 before providing guidance for the third quarter of 2023 and updating the full year. We'll then open the call for questions. 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. 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 that 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 the 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 on today's call are non-GAAP unless stated otherwise. Our GAAP results and GAAP to non-GAAP reconciliations are located in the earnings press release and in the presentation 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 will now turn the call over to Ken.

Thanks, Peter. Thanks to everyone for joining today's call to review our second quarter 2023 results. Total revenue in the second quarter increased 26%, driven by strong revenue growth in service, which topped 30% for the second consecutive quarter, with 34% growth in security subscription and a non-affiliated product growth over 45%, which is nearly 2 billion annual run rate. Building growth of 18%, leads to more normalized product revenue growth of 18%. We believe our building performance reflects large enterprise concern with the macro environment, in addition to some inventory digestion after two years of elevated 30-plus percent product building growth during the supply chain shortage. According to IDC's latest quarterly security tracker, In addition to having the number one union in firewall category for 10 consecutive years with over 50% market share, Fortinet is now the market share leader in both unit and revenue. Based on the latest Westland advisory OT security and cybersecurity report, Fortinet was named the only IT OT network protection platform leader. We are currently one of the top and the farthest growing OT security vendor in the market that Westland Advisor expects to grow to $33 billion by 2030. Fortinet's success lies in our broad, integrated platform, our proprietary ASIC security processor, and our ability to converge network and security both on-prem and in the cloud across a single FortiOS operation system. To leverage these advantages and drive future growth, In addition to our leading network security solution, we will increase our go-to-market investment in Universal SASE, SD-WAN, OT security, cloud security, and security operations. And we will dedicate more resources to support hybrid infrastructure and hybrid work. Today, we announced a new FortiGate 90G, our first next-generation firewall and secure SD-WAN appliance. with the new Security Process 5 ASIC that deliver industry-leading security functions, performance, scalability, and power efficiency at a cost-effective price. The 4890G is fully integrated with our FortiGuard AI power security service and has a secure computing rating that is up to 16 times greater than the average of a competitor's similar-priced model. by using over 90% less power than competing solution. We also announced two new SD-WAN service under the performance monitoring service to simplify operation and enhance digital experience, as well overlay service to facilitate rapid deployment, redundancy, and seamless interconnection of location with 4G SASE using SPA technology. This new SD-WAN service showcases our commitment to expanding our service, leveraging our leading installation base for additional future growth. We see a single-vendor SaaS solution opening a large new market and one where our sizable SD-WAN installed base can be leveraged as a significant market access point. Together with newly announced SD-WAN service, we plan to accelerate our global point-of-present POP deployment with a dual strategy of investing in our own POPs as well as working with service providers. Fortinet recently announced the result of an independent analysis by Forrester of the cost-saving and business benefit of deploying FortiGate next-gen firewall and FortiGuard AI-powered secure service within Enterprise Data Center which include more than 300% return on investment over three years, payback in six months, and 90% reduction in time spent on manual updates. In addition, an independent analysis by Enterprise Strategy Group established that customers who deployed 49 security operation solutions, such as 40 EDR and 40 NDR, reduced their time to detect and respond to incidents from an average of three weeks to one hour. This demonstrates the substantial impact that artificial intelligence, machine learning, and the integration of a Fortinet SecureOp fabric product can have on organizations' ability to secure produce rapidly expanding attack surface. Finally, New development in AI, such as generative engine, show a lot of promise to various applications in cybersecurity. We believe AI technologies can help us significantly to improve productivity and can be scaled to a large customer base in areas such as malware detection, threat hunting, event correlation and automation, as well as assisting network design and troubleshooting. 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. Keith.

Thank you, Ken, and good afternoon, everyone. Let's start with the key highlights from the second quarter. Billings growth was 18%, as was product revenue growth. Service revenue growth held firm at 30%, resulting in total revenue growth of 26%. OT and SD-WAN revenue continued to perform well, as revenue from these products were up 60% and 40% respectively. In a sign of our strength in the small and mid-sized customer segments, we added a record 6,500 new logos. Operating margins of 26.9% exceeded the high end of the guidance range by 140 basis points. Pre-cash flow was strong at $438 million, representing a margin of 34%, benefiting from the deferral of certain cash tax payments to the fourth quarter. Looking at billings in more detail, billings of $1.54 billion were led by non-FortiGate billings at over 30% growth, representing 34% of total billings. Non-FortiGate billings growth was driven by networking, FortiGate VM, NAC, and cloud. And as Ken mentioned, non-FortiGate is nearing a $2 billion annual revenue run rate. In terms of industry verticals, government and manufacturing topped the list as a percentage of total billings. With manufacturing up almost 50%, government and construction were up over 30%, while service provider and retail were up 1% and down 5% respectively. Retail was impacted by a very difficult compare as the industry vertical nearly doubled in the year earlier period. Billions growth varied by geos, with international emerging leading, followed by Europe and LATAM. APAC, and to a lesser extent, U.S. Enterprise, were challenged by difficult prior year comparisons. Deals over $1 million increased from 122 deals to 134 deals. Turning to revenue and margins, total revenue grew 26% to $1.29 billion, driven by non-FortiGate growth of over 45%, and service revenue growth of 30%. This was the second consecutive quarter of greater than 30% service revenue growth. Security subscriptions represent over 55% of all service revenue and continued their streak of strong, increasing, sequential quarterly growth dating back to Q1 of 22 at 23% to Q2 of 23 at 34%. Product revenue of $473 million increased 18%. Product lead times and backlog are expected to approach normal levels in the third quarter. Total gross margin of 77.9% was up 140 basis points, driven by a 160 basis point increase in product gross margin to 63.5%. Product gross margins benefited from earlier pricing actions and easing cost pressures and were partially offset by certain inventory charges. Service revenues were 63% of total revenues and delivered gross margin of 86.2%. Higher service revenue offset higher labor costs and increased cloud delivery costs as we continue to expand our cloud SASE delivery models. We see our single vendor SASE solution opening a large new market and one where our sizable SD-WAN install base can be leveraged as a significant market access point. We plan to accelerate our point of presence, or POP deployment, with the dual strategy Ken mentioned, investing in our own POPs, as well as working with third-party providers to accelerate our deployment. Operating income of $348 million grew 36%, outpacing revenue growth by more than 10 points, as operating discipline resulted in significant operating leverage. Operating margins of 26.9%, exceeded the high end of the guidance range and was up 210 basis points due to the strong gross margin performance in operational efficiencies. Earnings per share increased 58% to $0.38 per share and also exceeded the high end of the guidance. Looking to the statement of cash flow summarized on slides 7 and 8, free cash flow increased 55% to $438 million. Adjusted free cash flow, which includes real estate investments, was $498 million, representing a 38.5% adjusted free cash flow margin. Free cash flow benefited from the deferral of approximately $190 million in cash tax payments. As mentioned last quarter, these tax payments, together with other deferred 2023 tax payments, are due to be paid in the fourth quarter. Capital expenditures were $77 million, including $59 million of real estate investments. Cash taxes in the quarter were $38 million. The Board recently increased the company's share repurchase authorization by $500 million, and the total available share buyback authorization is now approximately $2 billion. Now I'd like to share a few significant wins from the quarter that exemplifies the strength of our broad and integrated platform. First, a global pharmaceutical leader signed an eight-figure deal to adopt Clorinet's cybersecurity fabric. investing in our OT-aware secure networking architecture, as well as our AIOps and threat intelligence solution. Recognizing the market shift to a platform-based approach to security, this company selected Fortinet to secure its highly regulated and sensitive medical data as it continues to drive global operational and financial efficiencies through our broad, integrated, and automated platform approach to cybersecurity. In another deal, One of the largest U.S. school districts, which had recently refreshed its data center firewalls with FortiGates, was seeking to improve its network security posture with a NAC solution that offers better visibility to the devices connected to the network. Fortinet competed against multiple peers and was able to win due to FortiNAC's ease of implementation, centralized management capability, and superior risk remediation, as well as the tight integration with the district's existing Fortinet Security Fabric. This high seven-figure deal was the largest NAC deal in Fortinet's history. Finally, in a seven-figure displacement and our largest 40 SASE deal ever, a large bank on its digital transformation journey was searching for a single vendor SASE solution for its hybrid workforce. It selected our 40 SASE solution for its over 5,000 users as it integrates SD-WAN and SASE into a holistic solution and delivers comprehensive security both from the cloud and on-prem while ensuring consistent security policies for all users regardless of their location and wherever applications are being accessed. These transactions illustrate how Fortinet's platform strategy, integrated operating systems, and proprietary ASIC technology continue to resonate with customers. Given the heightened interest in AI technology, We could not do this call without discussing Fortinet's investment and innovations in AI. Fortinet has been at the forefront of AI and machine learning innovation for many years, leveraging deep learning, artificial neural networks to power our products and security services, enabling a faster, stronger, and more accurate defense for our customers. One of our first AI-powered use cases was the introduction of the virtual FortiGuard threat analyst. FortiGuard addresses threats in real time with machine learning, coordinated protection, and is extensively used in malware detection and threat hunting. Every time a threat is identified, FortiGuard generates threat intelligence that automatically updates defense signatures across the fabric. In cloud environments where scale and speed are critical, AI and machine learning can help security teams keep pace with threats on multiple fronts. All of this happens seamlessly and behind the scenes. Today, our platform ingests and analyzes, on average, more than 100 billion events every day to deliver over 1 billion security updates daily across the Fortinet security fabric and ecosystem. While many of our competitors OEM their security from different security vendors, our AI-driven FortiGuard threat intelligence has been built in-house, which allows us to use AI across different sources. Adversaries increasingly are using AI in their playbooks to drive cyber attacks, which only increase the rapidly evolving cybersecurity threat landscape. We continue to invest in AI and machine learning technologies across our products, including generative AI, natural language models, and other implementations to enhance, simplify, and automate security for our customers. Before moving to guidance, I'd like to offer some observations about the second quarter and about the industry. Regarding the second quarter, we believe macro uncertainty impacted our buildings performance through average contract duration and in the second half of June, an elevated level of enterprise deals pushing the future quarters. We saw shorter contract duration with the average term decreasing by 1.5 months to 28 months, creating a four to five point buildings headwind year over year. Normalizing buildings growth with a change in contract duration yields buildings growth in the low 20% range. Having some level of enterprise deals push to future quarters is not unusual. In Q2-23, however, an unusually large volume of deals that we expected to close in June instead pushed to future periods. From a market perspective, CIOs continue to prioritize and invest in securing their organizations in the face of rising cybersecurity threats. We see new regulatory requirements, such as those recently announced by the SEC and the EU Cyber Resilience Act announced earlier this year, that will continue to provide market tailwinds as organizations further increase their cybersecurity investments to comply with new stringent cyber regulations. The cybersecurity industry remains highly relevant as CIOs prioritize cyber spending within their overall IT budgets. As such, the longer-term demand drivers for Fortinet remain very solid. That said, we do see a return to more normal seasonality for Fortinet in the back half of the year, as tailwinds such as the supply chain-driven growth subsides, and we cycle prior period price increases. Moving on to guidance, as a reminder, our third quarter and full-year outlook, which are summarized on slides 11 and 12, are subject to the disclaimers regarding forward-looking information that Peter provided at the beginning of the call. For the third quarter, we expect billings in the range of $1,560,000,000 to $1,620,000,000, which at the midpoint represents growth of 13%. And it's consistent with our quarter-over-quarter seasonality prior to the pandemic. Revenue in the range of $1,315,000,000 to $1,375,000,000, which at the midpoint represents growth of 17%. 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 35 cents to 37 cents, which assumes a share count of between 795 and 805 million. Capital expenditures of 100 to 130 million. Non-GAAP tax rate of 17%. Cash taxes of 25 million. And as previously mentioned, backlog is expected to approach normal levels in Q3. For the full year, we expect billings in the range of $6,490,000 to $6,590,000, which in the midpoint represents growth of 17% and applies slightly below normal seasonality in Q4. Revenue in the range of $5,350,000 to $5,450,000, which in the midpoint represents growth of 22.3%. Service revenue in the range of $3,350,000 to $3,410,000,000, which at the midpoint represents growth at 28.2%. The service revenue guidance implies product revenue growth at 13.5%. Non-GAAP gross margin of 75.25% to 76.25%. Non-GAAP operating margin of 25.25% to 26.25%. Non-GAAP earnings per share of $1.49 to $1.53, which assumes a share count of between 795 and $805 million. Capital expenditures of $335 to $385 million due to our continued cloud data center and facilities investments. Non-GAAP tax rate of 17%. Cash taxes of $460 million with approximately $380 million in the fourth quarter. We continue to execute our long-term strategy and remain confident in the strategy and our solutions. While it's a little early to be providing guidance for next year, we would expect our near-term performance to represent a short-term trough. Given our confidence in our solutions, our offerings, and taking into account that growth comparisons will ease as we move through 2024, at this early stage, we would expect buildings growth to approach high teens by the fourth quarter of 2024. And with that, I'll now hand the call back over to Peter to begin the Q&A session.

Thank you, Keith. Thank you. Yeah, just one quick reminder before doing the Q&A, if you could please limit yourself to one question, one follow-up question. Operator, you can open the call.

Thank you. And as a reminder to everyone to ask a question, please press star 11 on your telephone and wait for your name to be announced. And to withdraw your question, You can press star 1-1 again. Our first question is from Brian Dickey-Morgan. Your line is open.

Hi. Good afternoon, and thank you for taking the question. Ken, I think you noted that, you know, and Keith commented to it as well, reflected, I guess, that billing's performance and guidance reflect enterprise concern about the macro. Could you give a little bit more color there and what you saw from a macro perspective? And I think you pointed to weak service provider business. I think investors might draw parallels to what they saw with Juniper last week on the carrier side. Maybe if you could include a few thoughts on how dynamics there may be similar or different with regard to what you see, and then I have a follow-up.

Sure. I think for the Care service provider, we do see they're probably maybe behind offer some service. Because a care service provider, if you look back 10, 15 years ago, is the biggest market, about 30% market share comes from a care service provider. But nowadays, security need additional service, like some SASE, all these additional security functions in the SASE, which service provider kind of behind. So we're still working with them closely, trying to help them accelerate the service. At the same time, we're also starting to invest a little bit more ourselves, which also, like together with the new service we announced today, the two new SD-WAN service, we feel investing in certain infrastructure that will help you drive a lot of new service going forward in the security space, and also can help a service provider to kind of accelerate some of their security service beyond the traditional security service they have.

Yeah, I would probably add to Ken's comments, particularly as we talk about service providers, but some of the other verticals and customer segments. And I think there's some lessons that we can see from, for example, manufacturing, which did extremely well in the quarter. They continue to have, I feel they think they're under pressure in the threat environment, so you see them spending fairly richly. It's no surprise if you look at the government sector, which was strong also. They have budgets in a slowing economy that maybe some of the other industries don't. And the other end of the spectrum, Ken talked about service provider, and people, I think, are aware of that story there more broadly, but also retail. I think retail is really a very clear indicator of a vertical that can be one of the first that's sometimes impacted by a slowing economy, but also, and Ken made reference to this in his comments, this concept of digestion. You know, a lot of purchasing around SD-WAN technologies and implementations. A year ago, you saw very, very high growth a year ago, and now going through a digestion period such to the point that it's actually negative growth in the retail vertical.

Also interesting, some cloud provider also starting getting into the security space, which also kind of... confuse some of the enterprise customers. So that's also sometimes it takes a little bit more time to evaluate all different solutions. So we do believe there's a hybrid approach on-premise in the cloud and all will be fast for the customer. Even the cloud, probably much more expensive. Our calculation average is about 3 to 5x more expensive compared to on-premise, but the combined odds together probably will be the best solution to customers.

Got it. That's helpful. Maybe a quick follow-up for Keith. I think you talked about a re-inflection, the high teen billings growth next year. How does performance this quarter and your outlook for the rest of the year impact the 2025, I guess, $10 billion billings target that you'd previously thrown out there?

Yeah, I think that as we go through the second half of the year and we enter into our normal planning cycle for 2024, I think that'll be a logical output at that point in time to think through what we're seeing in terms of our 2025 targets. Okay, that's helpful. Thank you.

Thank you very much for your question. One moment. Our next question comes from Gabriella Borges with GS. Your line is open.

Hi, good afternoon. Thank you. Keith, I want to stay on the medium-term outlook, your comment on high teens' billings growth by 4Q24, if I heard it right. Maybe just talk us through how you thought about de-risking the six-month and the 18-month kind of outlook, and what are some of the leading indicators you're looking to determine when billings growth and product revenue will trough? Thank you.

Yeah, I don't know, Ken, if you want to talk about longer-term trends in the industry and And I'll avoid guides for 2024 if you do that.

Yeah, if you look back to like 30 years, which I'm in the industry, network security still have a pretty good pace of growth, probably between 10 to 20% on average in the last like 30 years. And we feel we have a very unique, huge advantage solution, which we, we're the only one build our own ASIC. You can see the product we announced today, which has a probably average about 10x better performance, more function compared to a competitive solution, and also much less energy consumption, probably like 90% less energy consumption. So that's where the new SP5 actually, the first product announced actually is that we have a 14 application engine integrated into the ASIC chip, probably more than double compared to the previous version. That's also helping drive the next few quarter growth, which probably every quarter we may plan to announce a new product using SP5. That's a huge advantage, and then also drives the long-term convergence of networking to network security, which Ghana agreed by 2030 the network security will be larger than the traditional networking there. So that will continue to drive the network security side growth. On the other side, we also mentioned a few other areas. We see kind of the non-for-the-gate part also growing pretty strong. So 45% is part of it because consolidation, part of it because certain like security budget allocation to certain cost spending can be allocated to some security. And the other part also kind of like how to manage among different kind of resources. vertical and also some inventory aside. That's also we try to balance. We do believe things will be recovered in the later part of next year. And because the last two years we see quite a strong product revenue growth, some quarter even over 50%, which is not quite normal, but it's when things get more normal, so the will be pretty much returned to the investor average in the last 23 years, which is about 10% to 20%.

Yeah, and as I kind of take that commentary and pull it forward a little bit and just say Q3 and Q4, and I suspect I'll get a fair amount of opportunities to talk about the guidance-setting process for Q3 and Q4, I guess I would start off by saying we've certainly seen over the last two or three years in the various environments we've been in, you've got to be fairly nimble in terms of your assumptions and what you're looking for. And with that in mind, you know, I think I called out in the comments, you know, to see the level of deals that pushed in the second part of June, you know, was a new development. We always have linearity of the deals closed to see the deals push. And I think one comment I would offer is that as you look, as I went through the Q3 guidance setting and the roll-up, you know, the assumptions for Q3, whether to close rates in term and things of that nature and push, I would say look a lot more like the assumptions that we saw in actual results for Q2. than maybe what we saw with some higher rates or better rates earlier on. So I think there's some caution built into that, if you will. I think also if you kind of look at the results of where the guidance ends up, you can look at top line growth in Q3 versus Q2 that I think is in the low single digits growth sequentially. And that's pretty much in range of where we've seen Q2 to Q3 historically. And we would expect that again. And then maybe just a little more caution in the fourth quarter where, and again made a comment earlier, that the seasonality assumption that falls out of the guidance for the full year and is applied to the fourth quarter actually suggests a lower level of growth in the fourth quarter than we've seen in other periods. You're offering a certain degree of caution, number one, but also acknowledging that Q4 last year was a very strong quarter and pretty tough to compare.

Also, we do see some strong growth in the new area, like ST1-OT, which grew 40% and 60%. Total count on 25% of units. And also the 5G growth not quite stopped yet. So we all have the best product for all these new solutions. So that's additional growth thrive. So we're keeping developing.

That all makes sense. Thank you. And just to clarify, is it safe to assume that 4Q, or are you assuming that 4Q billings will be the trough for billings growth?

Yeah, I'd have to go back and look at the actual compares because the compares start easing, and I don't want to mix up bookings and billings in this conversation because the timing is a little bit different. But I think that the growth in billings in Q4 and Q1 of last year and Q1 of this year were very, very strong.

Also, you can refer to the finance presentation number 10 page, which we go back to 13 years since we IPO 13 years ago. So there's some kind of a growth, some kind of margin information.

Yes, I do like that slide 10. Thank you for calling that out. Okay, thank you.

Thank you.

Thank you very much.

Our next question will come from Paul Liani with Bank of America. Your line is open.

Yes, thank you. I'm going to ask my two questions together with your permission. The first one is Palo Alto is posting their quarterly call for Friday evening, which is always a bad sign historically for a bad quarter. And then you are reporting weaker than expected, although you were very positive last quarter. I remember the calls. So does it mean that the environment deteriorated in the last three months? And if the environment deteriorated, what is the source for it? Meaning is it the backlog drawdown issue that we were concerned with before? Or is it that customers are deciding not to buy, push out? I'm trying to understand the meaning of both you and Palo Alto, you know, two successful companies kind of comments. The second question is, Keith, in your remarks, you said that projects were pushed out. But if it were pushed out, why do we see a deceleration, continued deceleration into 3Q and 4Q? Because I can back out your 4Q guidance. And Billings is declining from 18% to 13% to 11%. And if it was a push-out, then we would have seen recovery in the second half from push-outs from 2Q. So how do you connect your comments about push-outs versus quote-unquote cancellation to the numbers, to the guidance? Thanks.

Yeah, I'll go first, and then Ken can talk about what his friend down the street is doing. I'm not doing it to the best of his knowledge. As I kind of alluded to, yes, I had pushouts in the quarter. I'm happy with what I saw in terms of July on deals getting closed, but I retain the concept of continuing pushouts in Q3 and Q4. I'm not here to suggest that there's going to be a one-quarter recovery in that. I think that this is going to take a little bit longer. Through this, the economy kind of normalizes and this digestion process goes on. So I think it's really, yeah, picking up something in Q3 from Q2, but I'm also anticipating some I'm going to see some things move from Q3 to Q4. And also the compares, you know, if you go back and look at it, Q3 and Q4 on the buildings line, you know, those are pretty attractive numbers that we put up in Q3 and Q4 last year. What's he up to?

I don't know why Paul out of select the Friday afternoon, which is probably I'm not the one to answer the question. But on the industry side, We do see some companies, especially large companies, be more tight on the budget and also kind of take a little bit long time to close in. It's not just that this quarter basically pretty much starting early this year. There's some signs of that one. How long will last is tough to say, but usually the security, if they're starting to underspend, And then they probably will be starting to go back up after probably a few quarter. On the other side, you do see when the big environment is starting kind of tough or tight, they tend to be more hung on the current product, current solution, and then buy more service, which we also try to help in customer leverage whatever they have on hand to offer more service, like the SD-WAN service we announced today. So that's the service revenue starting kind of doing well, leveraged all kind of the last few years, the product revenue growth, which will already be the number one in the product revenue in the whole network security space, which is over 28% market share, and also the unit share is over 52% market share. So I think we'll continue to keep leading in the space, and there is new technology solution like the 4890G we announced today, but it's... For us, it's more focused on long-term, so we do believe the long-term convergence of network to network security, we feel we have the best technology product to meet that challenge. And at the same time, the short-term environment, we tend to also see as an opportunity to keep gaining market share.

Got it. can you talk about me i know you don't provide backlog but can you talk about the backlog trends and how much of what we're seeing last quarter this quarter next quarter is is still supported by backlog versus the environment itself i'm we are all looking through this um the question is whether first half of 24 for example we can get to single digit growth instead of the double digits you talk about the end of the end of the year so I'm not asking you for guidance for first half, but trying to understand how much of current trends are supported by backlog.

Yeah, the backlog, I'd say, is already back to normal now, back to before the supply chain issue. And you can see last year, towards the middle to the end, we already see the 40K, we already saw the issue. The majority of most backlogs all come from some network-related products. That's also been eased up in the first half of this year. I see backlogs kind of back to normal before the supply chain issue. And they do have certain cancellations. I see the cancellation probably double-digit.

I think Ken's giving you not the accounting answer on backlog numbers, but the CEO version that he's done worrying about it, and he knows the company can manage their way through it. From a numbers viewpoint, we still have some backlog that will pick up some benefit, most single-digit benefit in Q3. And then to Ken's point, we think that largely, as you get out of Q3, we'll be back to very close to normal backlog numbers. Great. Thank you.

Thank you for your question. One moment, please, while we compile the roster. Our next question is from Brad Zelnick with Deutsche Bank.

Thanks very much for taking my questions. I want to ask one of Tal's questions maybe a little bit differently. You know, a lot of what you shared suggests your market position remains strong, and we've always thought that, you know, the price performance advantage of your architecture should enable you to actually take share in a tougher environment. I guess what many are trying to figure out is if it's tough for Fortinet, does that implicitly mean it's tougher for others out there? And is there anything maybe you can share on competition that would be helpful, perhaps win rates or pricing dynamics that you're seeing in the market?

I think we still have the best solution, especially at the ASIC chip. So the product revenue has still grown at 18% compared to, I think, chip points of minus 12%, I believe. And some other vendors say it's low single digits. So we still feel we're keeping gaining market share. On the other side, we also see some consolidation. So it's leveraged our installation base. We see some of the other products starting kind of helping sell. But on the other side, probably two other kind of maybe timing-related issues. One is you can see the last two years on the part of revenue growth, which is on the I think it's page three. Oh, no, sorry. Page four. Oh, no, page three or page four, finance statement there. Because, you know, product revenue growth is probably like 40%, 50% in some quarter, but all over 30% in the last two years. So I do believe some kind of inventory is being held by a certain customer or some other – other, like, partner or kind of service provider channel. And we also kind of changing the policy, service grace period policy early this year, I think in March or April, which instead of give some of the channel, like, one year, they can enable service, we tighten that up to, like, 90 days, which can help reduce some inventory level in certain partner there. And the same time we do announce the SP5, I think it's early this year, and today is the first product available based on the new ASIC SP5, which probably like four or five times better performance, more application being accelerated, and the same time, the same cost. And it's kind of a, I do believe certain partners, certain customers may be also waiting for some of the new products, leveraging this technology. So that maybe also has certain kind of impact.

Yeah, Brett, I would pre-question and kind of follow on with Ken there. When I look at the win rates for, say, our top three competitors, right, who they are in the firewall market, I'm not really seeing a change in the win rates, the win-loss rates. They were quite consistent, maybe improved in one of the three cases of the names that we know. I think that what we don't know is how much it is specifically to us, was that we had deals teed up for the last couple of weeks of the quarter that were on a path to close, and they did not close. So, you know, how the question becomes, you know, is that something about the macro and the enterprises that are pushing out spending a little bit, or is it, you know, some area that we need to improve on in terms of how we go about our own internal inspection and forecasting and looking at the detailed deals, right? We'll know more about that as time plays out.

Yeah, the retail slowdown is more because of very strong growth. One year ago, almost double. Now it's going to slow down. The carrier service provider is still not ramped up yet, so we do hope they will ramp up soon.

Thanks for that, Color. Kenny, and just my follow-up, Keith, as we think about pricing, which has been a tailwind across the whole market, I think, given supply constraints over the last couple of years, Can you give us any update of what the trends are now as supply eases and what's embedded in your assumptions for your guide on billings for this year and next? Thanks.

Yeah, I think that what we look at, we're back to our approach we've had for many years when we introduced a new product, and you heard about the 90G today. Our starting point is, even though it has superior functionality, capacity, throughput, et cetera, is we generally price that along the lines of its predecessor. I think one thing that we're seeing as we move into the second half of this year are some opportunities to take maybe some targeted pricing actions around use cases. For example, maybe if you get really far down the low end of the market where you're dealing with some low-cost franchisee models, maybe we would take some opportunities there to perhaps offer some incentives to our channel partners and such to participate in that market. So I think the margins are obviously very, very strong on the product side. and we have that benefit there. So I do think it gives us the opportunity to make certain investments in the second half of this year, whether you want to call it priceless or discounts or rebates or incentives to the channel partners.

Thank you. Very helpful.

Thank you for your call. Our next question is from Angie Song with Morgan Stanley. Your line is open.

Hi, thank you guys all so much for taking my question today. In terms of cancellation rates, could you guys give us any directional color on backlog cancellation rates and, you know, what's assumed in your guidance by year end? Thank you, and I have a follow-up after.

Last quarter, I think cancellation rate we said was high single digits. This quarter, we'd say it's low double digits, right? And I know, you know, as backlog continues to subside, as Ken pointed out a moment ago, you know, it's not really going to make that much of a difference whether that cancellation rate goes from low double digits to mid-teens or something or even 20.

Got it. Thank you. And just as a follow-up, what percentage of revenue came from SD-WAN and OT security this quarter?

We see together over 25%, pretty similar to last year quarter, yeah. but also going pretty strong, 40% SD-WAN, 60% OT.

You're over 25% of the bookings number. I don't think we've given a revenue number for that.

Perfect. Thank you, guys.

Thank you. Our next question comes from Socket Kalia. Excuse me, from Barclays. Your line is open.

Okay, great. Hey, guys, thanks for taking my questions here. Ken, maybe just to double-click on the competitive question a little bit, but zero in on one segment. I'm wondering how you're seeing SASE vendors in this market, meaning do you feel like the – maybe backing up. Keith, very helpful comment just on how the competitive win rates trend versus the other traditional network security providers. But when you look at SASE – Do you feel like the growing prevalence of SASE is impacting firewall appliance decisions at all?

I think it's a little bit different market. Somehow the service provider, the traditional telecom service provider or the security service provider, they are a little bit behind in the last five to 10 years. So that's gave the SASE provider opportunity to offer the service, but I do believe A lot of our telecom service provider, cloud provider, they have a huge advantage on the infrastructure and the cost advantage to offer some additional security service, which we're also working closely with them. And at the same time, we also invest some of our own kind of infrastructure because also a lot of our additional service beyond SASI, like the SD-WAN, some other 40-car service also needs some of the infrastructure which will make a more profit model, cost-efficient model, compared to some other SASE provider they have to whether lease or whatever, which tend to like double, triple the cost compared to the similar service, they're owning the infrastructure. But it's the new service offered by the SASE provider we do see, we just saw the enterprise need, which we also, started to invest more in this area.

Got it. Got it. Keith, maybe for you, for my follow-up, very helpful commentary just on the billings duration in the quarter. I think that definitely helps bridge the gap with at least the guide on billings in Q2. But maybe looking forward, how are you thinking about billings duration for the second half of this year? And I don't know, is there a way to kind of do the same exercise? Like what would billings have been if the duration would have been in line with your original plan?

I may need a spreadsheet for the second part of that question. No, no problem.

We can take it offline.

That's fine. I think there's been conversation over the last, say, three or four quarters about would duration slow down, and we commented that we had seen some slowdown in duration, not one month a quarter, but it would kind of bounce around a little bit. The point I'm making is when you're measuring year-over-year growth, we lost one and a half points of duration, which works out to be about four or five points of growth. So when you're making the comparison on a growth basis, it really is a factor there. And then if you want to get into the spreadsheet part of it, remember that product is not impacted by duration, only services are, so you get a partial impact. I think if you're looking forward, as I made the point, as we look at Q3 and Q4, The duration assumption, I would say, is in that pool of things that I've looked at what we saw in Q2 in terms of actual results and how some of those metrics and assumptions that go into the guidance setting process differed from what I've been seeing for the prior few quarters and placed a very heavy reliance on what I saw in Q2, whether that feels the push or that term or a bucket of other things. So without going into specifics, I would probably answer that question that way.

Very helpful. Yeah, some additional point of SASE is really especially a lot of companies starting to return to work, return to office. So we do see a lot of like we call it universal SASE, which is supporting both on-premise in the office and also work from home. Because if you're back in office, forward office traffic to the part, SASE provided and then process sent back to the office does not make much sense. And at the same time, we do see a lot of leverage on SD-WAN leadership there. We do see a lot of required single vendor SASE. And also some bigger company also, they try to do, they call it a private SASE solution. So instead of a process of SASE traffic in the service provider part, they want to process in their own kind of data center infrastructure, which also will be a big potential market going forward. Thanks, guys. Thank you.

Thank you. Our next question comes from Shal Eyal with TD Collins. Your line is open.

Thank you for taking my question. Good afternoon. Keith or Ken, can you maybe talk about the performance that you've seen with your go-to markets as it relates to your token sellers. Was there anything non-balanced this quarter?

I'm not quite sure. Are you looking for the distribution of salespeople hitting quota? I'm not sure that followed the question. Actually, I'm looking for

your value added resellers, your notable ones, the biggest one. And whether performance was even or balanced or not, during the quarter.

Yeah, I don't have that data handy, to be honest with you.

Yeah, we do see the some release from exclusive network, which probably One of our biggest distributors also, we are also one of their biggest distributors, probably 30% business compound, but they're a little bit more.

Sorry, I thought you were talking about resellers. I'm sorry. No, no, no. You're asking the right question. You're talking about distributors, yeah. Yeah, I think it's a similar common as we are seeing. Yeah, I don't think the mix of our business, if you will, shifted at all significantly. We look at our top three and our top six distributors. You know we're fairly concentrated in that regard. That mix doesn't really change all that much, you know, maybe a point or two in a quarter. And there wasn't something that we saw that jumped out there at us.

Yeah, also even go back to the history also going forward. Also, pretty similar kind of a forecast, I believe. Yes. Thank you.

Thank you for your question. Our next question comes from Joseph Gallo with Jefferies. Your line is open.

Hey, guys. Thanks for the question. Given the breadth of your platform, you have a better vantage point than most. When you talk to CISOs, where is the relative health in the cyber budgets and where are you seeing the most resistance? And then given your optimistic comments on 24, what wins confidence that this is only a one to two quarter digestion period? Is there any historical context to support that?

In terms of CISO spending, obviously there's The things that are getting media attention out there now, I suspect if we sit down with a CISO, they'll be talking about it, whether that's SASE or something with some of the AI technologies or what have you. But I don't think that CISOs and CIOs can get away from having to take care of pretending they're knitting, if you will, with their infrastructure. There always seem to be new use cases for firewalls and opportunities, if you will. There's use cases that still exist on-prem that need to be secured. There's new use cases in the cloud, the edge, etc. I think it's a very difficult career position to be at CISO right now with budgets and threats that are after them. As it relates to 2024, I think we'll go through our planning cycle more religiously as we do the second half of the year. I think the point that Ken and I were making is really as we move back to a more normal buying pattern after we move through the supply chain and the pandemic and so forth, that's what the industry has been historically, and we would have every expectation that we'd be able to get back in that sweet spot, if you will. And I would also note that it's not a static comparison, and by that I mean the compares get easier, it seems, each and every quarter as you go through 2024.

Yeah, so we talked to they still have a certain shortage of people they can leverage to supporting for the work environment. And so that's where they tend to maybe more try to use certain service kind of approach. On the other side, they do see they need to make sure that the new infrastructure like whether supporting back-to-office or supporting like we call it universal SASE, universal AT&A environment because there's like so many tech service that in kind of impact and plus the new area like OT security, that's kind of a, but also certain security budget, they also, because some company, they commit certain cloud spending Sometimes leverages that commit spending for certain security, we also see some of that case. So that's what's happening. So that's where we're also kind of keeping hands or helping the secure operation, which is also most of CISO feel how to support in their operations are pretty big to help them to solve the issue there. And also levy some kind of AI, some new technology, and also kind of a more broadly deployed network security inside the infrastructure. It's also supporting hybrid work environment is also quite a high priority for them.

Thanks. That's very helpful. And then I guess as we work through this digestion period, how should we think about investments and hiring? You've outperformed in the first half on profit, but yet your guide doesn't necessarily reflect a continuation of that. Where should we think of the incremental investments from here and the classic growth versus profit debate at billions moderate? Thanks.

We're still hiring, but also the hiring probably will be a little bit behind on the top-end growth. Make sure we're keeping improving the productivity efficiency, but also we're probably will also try to have certain hygiene process, which we kind of not quite doing the last two, three years during the pandemic, which certain low performer, we probably need to be kind of more disciplined to have certain performance review or kind of a discipline there.

Yeah, I would use that to kind of come back to, I think, Shiloh's question and maybe make a couple points. I think that, as Ken kind of pointed out, we've had a lot of salespeople. We certainly have sales capacity to deliver on the numbers. At the same time, I think we've been very faithful to when we talk about 25% operating margin, and you see us continually coming in above that. So we have the opportunity there to invest more. And on that note, I think that the conversations with the channel partners, the distributors that we're having, I think they're much more informative, deep, detailed at the right levels now than they were a few years ago. There's a lot more cooperation, information sharing with the distributors. And I think a byproduct of that is I think there's some opportunities for us maybe to invest in our channel partners in a variety of different ways as we go through this next 12, probably six to 12 months.

Yeah, I kind of keep referring to the page 10 question. The last 13 years, the growth margin. So that's where we have the margin, and we've been getting profit all these 13 years since IPO. So if we need to invest in the growth, we definitely have the margin to do that. But on the other side, we also want to keep a healthy model and take care of both on the growth and margin.

Thank you.

Thank you, Joe. And our next question comes from Andrew Nowinski with Wells Fargo. Mr. Nowinski, your line is open.

All right, thank you. I want to ask about the geographic demand trend. So you saw, I think you saw strength in international regions in Europe. I was just wondering, you know, how sustainable do you think that demand is in those regions? Or are they just maybe one to two quarters behind the U.S. in terms of seeing the impact from the macro?

Yeah, I think that we have a competitive advantage when you look at Europe and parts of the international emerging where we are oftentimes viewed as being the incumbent and have number one market share. So in an environment in which maybe the IT budgets start to suffer more in Europe than they do in the U.S., which is not what we're seeing currently, right? Currently we're seeing the IT budgets are lower in the U.S. than they are in Europe based on some recent surveys. I think we're better prepared to work our way through that in Europe because of our dominant position in that market.

Okay, got it. And then I think you talked about seeing strength in the SMB segment, adding about 6,500 new logos. I guess I was wondering, as it relates to your universal SASE solution, can you just talk about maybe how you're competing against, if at all, against Microsoft's new Entra solutions that are targeting that market?

Yeah, we kind of more leverage our huge installation base and also the technology, the product, which address the network security. Microsoft definitely have some good customer base in the enterprise side, but on the network security, which is addressed more beyond the certain enterprise, definitely we have some advantage there. And also we have not seen Microsoft have any solution address network security municipal security area. So we do believe there's an opportunity for both companies. Got it. Thank you.

Thank you. That concludes our question and answer session. I would now like to turn the call back to Peter Salkowski for closing remarks.

Thank you, Teresa. I'd like to thank everyone for joining today's call. Fortinet will be attending investor conferences hosted by Deutsche Bank, Goldman Sachs, Oppenheimer, Rosenblatt, and Stiefel during the third quarter. Fireshare chat webcast links will be posted in the events and presentation section of Fortinet's investor relations website. If you have any follow-up questions, please feel free to contact me. Have a good rest of your day. Thank you.

This concludes today's conference call. Thank you for participating. You may now disconnect.