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spk10: Good day and thank you for standing by. Welcome to the Fortinet Q3 2023 earnings announcement. At this time, all participants are in listen only mode. After the speaker's presentation, there will be a question and answer session. To ask a question during this session, you need to press star one one on your telephones. You will then hear an automated message advising your hand is raised. To withdraw your question, please press star 1-1 again. Please be advised that today's conference is being recorded. I would now like to hand the conference over to Peter Sikowsky, Senior Vice President of Investor Relations. Please go ahead.
spk16: Thank you, Antoine. Good afternoon, everyone. This is Peter Sikowsky, 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 third 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 our call today by providing a high-level perspective on our business. Keith will review our financial and operating results for the third quarter of 2023 before providing guidance for the fourth quarter of 2023 and updating the full year. we'll then open the call for questions. During the Q&A, we ask that you please limit yourself to one question and one follow-up question to allow others to participate. Before we begin, I'd like to remind everyone that today's call 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 SECU 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. I want to take no obligation and specifically disclaim any obligation to update forward-looking statements. Also, all references to financial metrics that we make on today's call are non-GAAP unless stated otherwise. Our GAAP results and our GAAP to non-GAAP reconciliations are located in our earnings press release and in the presentation that accompanies today's marks, both of which are posted on the Investor Relations website. Ken and Keith's prepared remarks today for the earnings call will be posted on the quarterly earnings section of the Investor Relations website immediately following today's call. Lastly, I'll reference the growth that are on a year-over-year basis and what's noted otherwise. I'll now turn the call over to Ken.
spk15: Thank you, Peter. Good afternoon, and thank you to everyone for joining our call. In Q3, we exceeded street expectations in operation margin and free cash flow. However, building and product revenue fall below our expectations due to a slowdown in secure networking growth, along with challenges in self-execution and marketing efficiency. In response to the slowdown in secure networking market, we are shifting our marketing and sales teams' focus towards a faster-growing security operation and safety market over the next few quarters, all while maintaining our consistent focus on leading innovation in secure networking and the convergence of security and networking where we have been a leader for 23 years. While we anticipate limited near-term growth in the secure networking market, it is very important for Fortinet as we believe it enables our platform strategy with a massive footprint as the market leader in both firewall revenue and unit shift. The secure networking market is valued at $62 billion and is projected to increase high single-digit annually to $86 billion by 2027. Our consistent focus on innovating our industry-leading 40OS, which supports over 30 network functions, networking and security applications, combined with our ASIC-driven performance capability, which provides 5 to 10x better performance on average than competitors, continues to drive our market share gains. Secure networking remains a vital part of our strategy and a market that we believe will return to double-digit annual growth over time. We have been innovating for some time in the faster-growing segment of secure operations and SaaS. Secure operations, also known as SecOps, is a $46 billion market growing at a mid-teens annually to $78 billion by 2027. Fortinet's SECOP platform is comprehensive and integrated, offering EDR, SIM, SOAR, NDR, and other integrated solutions. Consolidation in a security industry demands seamless integration and underlying security tools. Fortinet's strength lies in its innovation and its ability to enable automation through a high degree of product integration. Our AI and SecOps product empower automatic response within second, all underpinned by a single consolidated management and analytic platform. In addition to SecOps, we have continued to increase our focus on SASE. Our $17 billion market expects to grow at a 20% compound annual growth rate to $36 billion by 2027. We believe Fortinet is the only company with a SASE service solution that can perform all functions in the cloud, all email and pies, all with a common operation system, including full networking and security stack, marketing leading SD-WAN, VTLA, and the management console. Our SASE service solution is supported by Google Cloud. With over 100 worldwide SASE cloud locations, together with our own 30-plus point of presence and our data centers. For our appliance-based use case, we accelerate SASE service function using our ASIC technology. For instance, we recently announced the 4DGate 1.8G with the security processor 5, which supported our full SASE offering, which included SD-WAN, firewall, secure web gateway, big lock prevention, and boost secure computing regions six to 54 times better than our competition. We anticipate that success in SASE market will first come from upselling SASE service to our installed base of tens of thousands of SG-1 customers, and from attracting new customers looking to leverage our single-vendor, integrated SASE service solution. Our industry leadership in both Farooq and SG-1 The two largest components of SASE provide us with a significant competitive advantage. We have a track record of successful execution and believe we are the only company with strong SASE service and the SACOP solution combined in the same operation system. This differentiation sets us apart and provides us with a significant competitive advantage over peers. While we expect top-line growth to be modest for the next few quarters due to challenging security networking comparison and our business transformation realignment towards security operation and SASE, we anticipate growth return to double-digit by the second half of 2024. We remain committed to generating healthy operation margin of 25% or greater in 2024 and 2025. 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.
spk02: Thank you, Ken, and good afternoon, everyone. As Ken mentioned, we are confident in our integrated 40OS-driven platform strategy, which is summarized on slides 6 through 10 of the earnings slide deck. As we look forward, we believe shifting our R&D and go-to-market investment into faster-growing SaaS-y and SecOps markets is consistent with near-term market opportunities. As shown on slide 10, SASE and SecOps account for 20% and 10%, respectively, of our business today. And as shown on slide 7, these markets are expected to grow in the mid to high teens annually. Secure networking, which currently accounts for 70% of our business, is expected to experience slower growth following two years of very robust growth. As a result, for the near term, we expect to deliver healthy profitability along with more modest growth. With execution and continued investment in the SASE and SECOP markets, we believe we can return to delivering mid- to high-teams top-line growth, and while continuing to deliver operating margins of 25% or greater. In other words, a return to balanced growth and profitability, which has led us to achieve the rule of 40 status in 12 to 15 years, as shown on slide 19. In a moment, I'll expand on the strategic shift by sharing a few of the tactical steps and investments. But first, I'd like to review some highlights from the quarter. We continued to add new logos at an impressive rate and saw top-line performance in small enterprise and software was strong, while operating margin and free cash flow were above expectations. We added over 6,400 new logos, supported by small enterprise customers, which grew bookings by 19%. Our efforts to manage personnel and other costs drove our operating margin to 27.8%, 230 basis points above the high end of the guidance range. Free cash flow was strong at $481 million, representing a margin of 36%. Looking at billings, starting from the third quarter of 2022, we saw a three-year compounded annual billings growth rate, or CAGR, of 26%, illustrating our ability to drive strong and sustained growth over an extended period. In Q3, however, billings of $1.49 billion represented growth of 6% as we experienced one month shorter contract duration, and importantly, lackluster appliance demand resulted from elevated product growth in earlier periods. In terms of industry verticals, education and government billings were strong, while service provider and retail billings were weak. Small enterprise billions growth was strong, while growth rates with larger enterprises disappointed. Billions growth varied by geo, with international emerging showing strong growth, while our much larger geos of Europe and the U.S. were weaker. Turning to revenue and margins, total revenue grew 16% to $1.33 billion, which compares to our three-year CAGR of 27%. The three-year CAGR was largely consistent with our 14-year CAGR illustrated on slide 18. Product revenue of $466 million, representing a three-year CAGR of 28%, was down 1%, reflecting product lead times and backlog aligning with historical levels and the lighter levels of network security demand Ken referred to. Service revenues of $869 million grew 28%, representing a three-year CAGR of 27%, Service revenue accounted for 65% of total revenues, driven by 34% growth in higher margin security subscriptions, which represents 57% of total service revenue. We mentioned the three-year CAGRs to illustrate how consistent they are with these same CAGRs starting from our 2009 IPO, which are illustrated on slide 18. Key to the three-year CAGRs, billings, product revenue, service revenue, and total revenue, are within five points of the 14-year CAGRs for the same top-line metrics, adding to our confidence in returning to higher growth levels. Product gross margins were down 310 basis points as we saw margin pressure related to inventory levels. Service gross margin was up 60 basis points as service revenue growth outpaced higher levels of cloud and hosting costs. Total gross margin of 76.9% was up 70 basis points driven by the increase in service gross margins and the six-point shift from product revenue to service revenue. Operating margin of 27.8% exceeded the high end of the guidance range, and operating income of $371 million was $33 million higher than consensus, and $20 million above the high end of our guidance range, reflecting our efforts to control spending. Looking to the statement of cash flow, summarized on slides 15 through 17, Free cash flow increased 22% to $481 million, representing a free cash flow margin of 36%, or nine points above consensus. Operating cash flow increased $68 million to 41% of revenue. Capital expenditures were $70 million, including $50 million of real estate investments. Cash taxes paid in the quarter were $26 million. As a reminder, Free cash flow benefited from regulatory relief in the form of deferred, estimated, and other tax payments in the second and third quarters, totaling $192 million and $18 million, respectively. In the fourth quarter, we expect cash taxes to total $345 million, including the $210 million of deferred tax payments. We repurchased 10.4 million shares of our common stock for an aggregate cost of $605 million in the third quarter. In October, We purchased an additional 7.7 million shares for $444 million, and our remaining share repurchase authorization stood at approximately $980 million at the end of October. Now, I'd like to share a couple of key SASE wins for us in the quarter. In a seven-figure upsell win, an existing financial services customer initiated their single-vendor SASE solution for 50,000 users. Fortinet was able to displace another incumbent, as the customer continued their consolidation journey with us, supplementing their earlier SecOps, cloud, and network security purchases. And in a six-figure deal, an existing SD-WAN customer continued their strategic transition to SaaS and cloud-based applications by adding our SASE solution for 2,000 users. We believe existing SD-WAN customers such as this one offer a rich cross-sell opportunity for our SASE solution. It's worth noting these deals closed before our recently announced partnership with Google Cloud, which significantly expands our pop coverage by adding over 100 locations, and prior to Gardner's release of the inaugural single vendor SASE Magic Quadrant, where we were named a challenger. By 2025, one third of new SASE deployments are expected to be single vendor. I should also note, Fortinet is recognized in nine Gardner Magic Quadrants, as shown on slide three. Now I'd like to expand on Ken's strategic commentary with some of the tactical investments we're making to increasingly focus our efforts on SASE and SecOps. In the areas of research and development and solution delivery, in addition to the new Google Cloud partnership I just mentioned and our own data center investments, we're continuing to integrate single vendor SASE features into 4DOS and continuing to expand our SecOps capabilities with AI technology and additional functions in enhanced integration, and finalizing co-development agreements with existing large enterprise customers to accelerate continuous improvement of our integrated enterprise-level SASE solution. Our go-to-market strategy on investments include actively promoting our challenger position in Gardner's single-vendor SASE Magic Quadrant, focusing on third-party certification of our broad and integrated solutions, including SSE and SD-WAN, and aggressively marketing Fortinet's competitive advantages and the key components of SASE, SecOps, and network security, as summarized on slide 10. Certifying 5,500 Fortinet sales professionals in SecOps solutions after already certifying these same sellers in SASE, which is the largest sales enablement motion in company history. Investing in sales comp plans to include incentives to sell SASE and SecOps capabilities to existing and new customers. Expanding partner roles deeper into channel partners, specializing in SASE and SecOps. And developing channel training that is focused on differentiating Fortinet's comprehensive and integrated SASE and SecOps capabilities. We believe Fortinet remains well positioned in the cybersecurity market, and the market shift to platform strategies is in early stages. According to Gardner, 75% of companies are pursuing a vendor consolidation strategy, reflecting the evolving landscape of cybersecurity in a highly fragmented industry with thousands of vendors. As shown on slide nine, Fortinet brings consolidation across SecOps, SASE, and network security, the three key growth drivers in our strategy. Organizations are recognizing that an integrated security solution with a single operating system is the best method to improve their security posture as this approach allows each security solution to share data and communicate with each other, reducing complexity and improving security effectiveness. Attempting to piece together best-of-breed solutions from multiple vendors can result in slower AI-driven technology adoption, significant security gaps, and a slower pace of identifying, reporting, and resolving security incidents. Moving to guidance, we continue to see increased deal scrutiny and longer sales cycles which is constraining our near-term results. We expect these longer sales cycles to continue, along with the associated budgetary scrutiny, and our fourth quarter guidance takes this into consideration. As a reminder, our fourth quarter and full year outlook, which are summarized on Slides 20 and 21, are subject to disclaimers regarding forward-looking information that Peter provided at the beginning of the call. In the fourth quarter, we expect billings in the range of $1,560,000,000 to $1,700,000,000, which at the midpoint represents a decline of 5%. Revenue in the range of $1,380,000,000 to $1,440,000,000, which at the midpoint represents growth of 10%. Non-GAAP gross margin is 75.5% to 76.5%. Non-GAAP operating margin to 27.5% to 28.5%. Non-GAAP earnings per share are $0.42 to $0.44, which assumes a share count of between $780 to $790,000,000. capital expenditures of $40 to $60 million, a non-GAAP tax rate of 17%, and cash taxes, as I mentioned, of $345 million. For the full year, we expect billings in the range of $6.95 million to $6.235 million, which in the midpoint represents growth of 10%. Revenue in the range of $5.270 million to $5.330 million, which in the midpoint represents growth of 20%. Service revenue range of $3,355,000 to $3,375,000, which at the midpoint represents growth of 28%. The service revenue guidance implies product revenue growth of 9%. Non-GAAP gross margin of 76% to 77%. Non-GAAP operating margin of 26.5% to 27.5%. Non-GAAP earnings per share of $1.54 to $1.56, which assumes a share counted between $790 and $800 million. capital expenditures of $220 to $240 million, non-GAAP tax rate of 17%, and cash taxes of $430 million. As we look forward to 2024 and transition from a period of elevated product growth, we can offer a few thoughts looking forward. In the near term, we will continue to focus on improving profitability. We expect product growth margins to be pressured in 2024. Nonetheless, we expect healthy operating margins that are 25% or greater. We expect to gradually increase billings growth through the year and approach double-digit growth by the second half of 2024, reflecting the progressively easier comps due to the easing of the headwind from backlog draws in the first half of 2023 and the benefit of our SASE and SECOP focus. We expect contract term to remain below our high watermarks of 2022. Consistent with prior years, we expect that the timing of service revenue growth trends will lag product growth trends Longer term, remain confident in our solutions and our ability to adopt our strategy to shifts in the market, taking market share as we increase our investments in SASE and SecOps, ultimately returning to balanced growth and profitability. I look forward to updating you on our progress in the coming quarters. And with that, I'll hand the call back over to Peter to begin the Q&A.
spk16: Operator, as a reminder, during the Q&A session, we ask you to please limit yourself to one question and one follow-up question to allow others to participate. Operator, you can open the call for questions.
spk10: Thank you. We will now conduct a question and answer session. To ask a question, please press star 1-1 on your telephone and wait for your name to be announced. To withdraw your question, please press star 1-1 again.
spk00: Please stand by while I compile the Q&A roster.
spk10: Our first question comes from Hamza Fardawalla from Morgan Stanley. Please go ahead.
spk06: Thank you for taking my question and good evening. Ken, maybe just for you, to what extent are you seeing SASE start to eat into firewall and network security budgets? Because clearly there's a There's a bigger focus there. There is a dedicated go-to-market effort there. So do you think that SASE is starting to cannibalize the firewall market to some degree?
spk15: I think it's a little bit different business model. SASE is more the service OPEX compared to the networking Libby mode CapEx. During the slow economy environment, cost was definitely more. towards service-based OPEX. So we also see some of our service providers kind of a little bit slower to adopt some of the SASI. We have been involved in SASI for a long time, and some of the service providers are kind of slower than we expected. So that's where we kind of are changing some of the strategy more aggressively, going sassy ourselves, and at the same time still working closely with the partner.
spk00: Okay. Thank you. Thank you. Thank you. One moment for our next question. Our next question comes from Brian Essex from J.P.
spk10: Morgan. Please go ahead.
spk08: Hi, good afternoon, and thank you for taking the question. I guess maybe, Keith, for you, as we look at the trajectory of product declines this quarter and billings growth, and I guess guidance implies that this is a billings trough this quarter, what observations might you have from other, we'll call them spending cycles, where you've hit? negative product or low single-digit product revenue growth and the degree of recovery that you've seen after those spending cycles? And what gives you the level of confidence in your ability to, I guess, return to double-digit growth for either product or buildings or both in the second half, understanding you're going to have easier comps as well?
spk02: Yeah, Brian, great questions, I should say. One of the slides that we added to the investor presentation for this earnings call actually maps out what you can see is a more cyclical nature of the business than maybe we've talked about in the past with product revenue. For example, 2017, I think we had product revenue growth of 5%, and that was somewhat of a low watermark. The market may have been due, and I think there's some analyst studies out there from other members of Wall Street, that have kind of suggested that the market was due for a little bit of a pause in firewalls. And I think we're seeing that now. And perhaps there was some delay of that pause because of supply chain issues and so forth, something that may have more naturally occurred in 2021 or in 2022. I think in terms of confidence broadly, I think that was the intention of looking at the CAGRs and the success of the company that Canada has led the company through since its IPO. and what those CAGRs are. And if you look at that combined with that new slide in the deck, you understand that there's going to be, there has been in the past, been volatility in the industry and in the company. But over the longer stretch, you see some very attractive CAGRs in that.
spk15: Long-term, we still believe the convergence of networking to network security will be happening, which also violated by, like I said, by 2030. the network security, secure networking will be larger than the traditional networking, especially in a complex environment, in enterprise. And so we do believe it's a huge market opportunity. We have a unique advantage with our integrated operating system, with our ASIC acceleration. We're keeping gaining market share in both secure networking and also in the SaaS market.
spk08: That's helpful. Thank you.
spk00: Thank you. One moment for our next question. Our next question comes from Fatima Bulani from Citi.
spk10: Please go ahead.
spk11: Good afternoon. Thank you for taking my questions. Keith, in your prepared commentary, you specifically called out the service provider and retail verticals. perhaps exceptionally weak in their buying behavior. And Ken was just sort of alluding to some of the challenges that are stemming from service provider buying behavior. But I was hoping you could provide a little bit more detail as to why have the spending patterns in these particular verticals become so dramatically weak? And was this in the scope of your assumptions as you were thinking about the pipe? Just wanted to get a better understanding of you know, how and why the buying intentions have sort of rolled over in these two areas specifically. Thank you.
spk02: Yeah, I think the service provider commentary has probably been reported by a number of other companies through this earnings cycle. I don't think that's a – the headline itself is not a surprise. I think the significance of the slowdown in the service provider, at least for what we saw in our business, was a surprise, particularly because it's a worldwide service provider number and not just in the U.S., But as I also noted in the prepared comments, we saw weakness in both the U.S. and the European markets, and that applies to service provider and to the retail sector. I think the retail sector probably is perhaps a little bit more prone to some of the digestion of SD-WAN projects that they're still working their way through. Maybe that's a little bit different, as well as some of the economic headlines were probably a little bit disconcerting to the retail sector in the earlier part of the quarter.
spk00: Thank you. One moment for our next question. Our next question comes from Tell Lani from BOA.
spk10: Please go ahead. Thank you.
spk13: I have two questions on the same topic. If you go back to the last two years, You talked a lot about non-appliance sales, meaning upsell, SD-WAN, which is an add-on service, and then non-fortigate. And when things start to slow, quote-unquote, we only blame the appliances. So the question is, in retrospect, when you look at things and you look at the other parts of the business and you look at the add-on sales and the other features, are they all based – on the ability of you selling appliances, meaning even if it's a non-40 gate, it's being attached to a 40 gate cell, and that's why it's going down with it, or an SD-WAN, et cetera. So first, just to understand kind of the total exposure of the company from all the successful products that you were able to sell over the last two years, and now in retrospect, just to understand how is the exposure to appliance. And the second question, which is related to it, is, If really it's about appliance sales, what is the outlook for 2024 when it comes to do you have any big refresh cycle? What could drive outside of easy comps that our comps are getting easier through the year? Is there anything that you're planning on your end to drive some kind of replacement or refresh of the appliances? Thanks.
spk15: Yeah, this is Ken. I think for... I see when they do need our clients to be in place to deliver all this SD-WAN function there. We usually offer SD-WAN as part of the 40OS, 40K function for free. We started launching the SD-WAN service last quarter, so it's still in the run-pop stage. We do believe long-term, all these surveys will keep accelerating, like the SASE market will grow faster than the secure networking market. I think that's where for certain, like, I think there's a chart on the presentation that shows some of the products and surveys, which I think is on page 19. You can see some of the cycle up and down there. Also, some of I do believe relate to the new ASIC and also product launch because we're just starting the new cycle of the new SP5, which we have one or two products that are starting launching, which gave us like five to ten times better performance and more function and the same cost. which also, combined with the supply chain, kind of elevated shipment of building in the last two or three years. I think all this combined together, I feel, have affected appliance sales in the last few months. But I do believe this, since we'll go back to normal, probably second half of next year. after the new product being fully launched, after the supply digestion, inventory digestion kind of goes through. Because we do see the long-term convergence still holding well. We have a position with a better integrated OS with acceleration. And our plan is a part of the whole solution. It's a hybrid solution, both our plan and the cloud, especially we call the universal SASE. So that's where there's some kind of cycle. If you refer to the page 19 of the presentation, we kind of probably go through that cycle right now.
spk02: Yeah, Tal, I'll maybe add to Ken's comments. I think you're correct in that, your inference. The vast majority of time our first sale to a customer is a firewall. It can be a virtual firewall or it can be a physical appliance, and really that is the beachhead to then go sell these other security functions and products. I think what you're seeing in part of the shift in strategy, and we talk about making the investments in not only SASI but also SecureOps, it's really that SecureOps product of family like EDR and SIM and SOAR and such that you're seeing that's doubling down on the investments there because While it's not the largest of the three market segments, it is the fastest growing, and I think we have the opportunity to participate in those markets more, particularly now that some of our products have reached a greater level of maturity. Got it. Thank you.
spk10: Thank you.
spk00: One moment for our next question.
spk10: Our next question comes from Sackett Kelly from Barclays. Please go ahead.
spk14: Okay, great. Hey, Ken. Hey, Keith. Thanks for taking my questions here. I'm going to ask two together. So maybe for the first one, Ken, for you, just maybe thinking about the long term and specifically in the SASE part of the business, when do you feel like Fortinet will have a solution that can compete head-to-head with other SASE solutions? Maybe the answer is now, right? But just want to hear how you think about it. And how big do you think this part of the business can be longer term? That's the first question. The second question for you, Keith, is it's great to see the operating margin be. Maybe you could just talk about how you're thinking about sort of midterm profitability, because clearly the business can generate higher margins than 25%. How do you sort of think about that balance now, kind of given some of the changes here?
spk15: Yes, the first answer is yes. Now we are head-to-head competing. And we also believe we have a much better solution, better integrated, and at the same time, much better cost ROI compared to other competitors on the SASE. And also the universal SASE is very unique because they offer both in the cloud, on the plans of Compass, all the same solution, which a lot of customers more like our solution instead of sometimes you have to deal with traffic, whether in office or office, have to forward to the POP, because our solution, you can process some traffic locally on campus within their appliance.
spk02: Yeah, and Sokka, you made a great point about whether you're talking about free cash flow or you're talking about operating margin. The company does very, very well on the bottom line, and the strategy has been to continue to reinvest that back robustly in both innovation in the form of R&D spending, but also in go-to-market, whether that's marketing or whether that's selling. I think what we're looking at right now with the slower firewall market, obviously we're trying to bring new solutions or better solutions to our sellers to sell when the firewall is a little bit slower. But I do think it's a worthwhile conversation. I'm looking at the sales coverage, if you will. We've talked for several years about how many in North America, for example, how many accounts do we want per rep? We started with 65, I think, four or five years ago. We were talking about that. That number is now down to 10. And at 10, you're probably reaching a point of where you're on the enterprise side. You're probably reaching a pretty good coverage model for our business. You could probably go a little bit lower, but that feels pretty good. I think there's another opportunity right now immediately in front of us in terms of how do we continue to support our channel partners, be they distributors or be they resellers, and make sure that we're getting the right level of mind share from them. So I would suspect there will be some investments in that part of the business as we go forward. At the same time, I think there's some opportunities here, and Ken's talked about it with us, about how to be more efficient in how we're spending our money, whether that's in selling and marketing or back office functions or what have you. We're not trying to guide to 2024 today, obviously, but we did think that it was important to provide at least some early thoughts in terms of maybe a floor for what 2024 should look like for us on the bottom line.
spk14: Got it. Very helpful. Thank you.
spk10: Thank you. One moment for our next question. As a reminder, if you would like to ask a question, please press star one one and wait for your name to be announced. Our next question comes from Brad Zelnick from Deutsche Bank. Please go ahead.
spk04: Great. Thank you very much for taking the question. I appreciate that as you lean into SASE and security operations, your most obvious advantage is in having an industry-leading install base. But for those of us that have always viewed Fortinet's distinct advantage as the price performance of your purpose-built hardware, and you've also had to go to market, both direct and indirect, that know how to showcase that. I'm just trying to get my head around all the changes in distribution, both direct and indirect, which... I appreciate, Keith, you made comments about sales enablement, but how do you think about the investment in dollars and time needed to get distribution properly ramped? And can you ever achieve the same level of sales productivity that you've enjoyed when the motion was more box-centric?
spk15: We do believe it's a fast-growing and sassy tech out-market business. the self-training, self-restructuring, and at the same time, more efficient marketing is very, very important. And also, we are continuing working closely with our channel partner, with our distribution network, to reach a very broad customer base. So we're also thinking the upsell, cross-sell opportunity is huge, and it especially goes to our partner network there. So I don't feel the investment we made in the past will be any issue or kind of any slow us down. We do believe we're actually helping us to expand in this more service-based asset market and also a more consolidation secular approach.
spk02: Yeah, and I would just build on Ken's comment, Fred, and all good and fair questions. it's not by accident we're talking about SASE. If you go back and think about it a little bit, we've been talking about it in a number of different ways. Ken's talked about the POP strategy, which now you see us accelerating that POP strategy with the cloud providers to come to market more quickly. The Gardner Magic Quadrant, I think, is a catalyst for the single vendor strategy and having us in the Challenger Quadrant gives us the bona fides, if you will, to have a lot of conversations. The single vendor strategy, that install base that you referred to, We went back and looked over the last two quarters. We've done several hundred SASE deals already. To be quite honest, that was without any real wood behind the arrow in terms of marketing support or sales support. It was really just how it grew. It's interesting. While I would have expected those first sales that would have been clearly dominated by SD-WAN, they were not SD-WAN customers. Oftentimes, there were just as many brand new customers coming to us for the SASE solution as there were SD-WAN customers or In some way, the third part of the pie were customers that are bars for other firewall use cases. So I don't, you know, in the expectation that we're going to be successful initially in the smaller part of the market, I don't think we disagree with that. When I look at that same mix of SASE customers, nearly 50% of those SASE customers that we've signed already would be in the SMB space. And then the remainder was kind of divided up between the larger enterprises and the mid-enterprise, so. I don't think we got here by accident. We may have chosen not to talk about it as publicly, but I think we're well positioned now because of the investments that we've made in the data centers, the POPs, the operating system, the Gardner Magic Quad, or the fact of the single vendor and the install base. You know, I think this is the right strategic shift for us to make at this point.
spk04: Thanks for that, Keith. And just a quick follow-up, and I know it's a topic we've spoken about in the past, but as SASE increases as part of the mix, and I know strategically you've partnered with Google to to help deliver the infrastructure. How should we think about the CapEx required to do this in a competitive way over the longer term? Thank you.
spk15: We do have a good partnership with Google and at the same time some other service providers like Digital Reality. We also built some of our own, like a data center, POP, over 30s owned by ourselves, which has really given us a more cost advantage So we're continuing that strategy, but that's going to need time to ramp up. So Google is a very quick solution for us, for customers. And also we feel we separate, we kind of realign the market into three different segments. Secure networking, SaaS and secure app is much clearer, much better line up with the customer need and also meet different customer demands. So that's much better, more clear compared to the previous one we have, whether the 40K or some other enhanced non-40K product. We feel this is a clear three-segment line-up quite well with the customer demand. So we're starting tracking based on this one. Also, we're starting compensating sales and the trend sales and marketing along all these three separate segments of the market. That will be more clearly to us internal for customers to a partner to really kind of drive what customers really need in the current environment.
spk02: To Ken's point, last quarter we were talking about 20 POPs because we were building them ourselves. Now you're talking about over 100 locations, well over 100 locations. So I think there's a go-to-market opportunity there that this brings to us. I think longer term, and we know that one of our competitors, this is the approach they take, and we have pretty good visibility, obviously, of what their margins are and their investments there. And there's another player in the space that's much more building their own POPs, if you will. POPs individually are not huge things, right? I mean, there are a single-digit number of racks that really have a POP, I think. So I do believe you need some forward-stage data centers. And I think that's consistent with our strategy that we've talked about, about increasing more and more hosted delivery services, and particularly in psych ops. So I think this is not something that we're going to surprise people with in terms of our capex spending.
spk04: Makes perfect sense. Thank you.
spk00: Thank you. One moment for our next question. Our next question comes from Adam Tidal.
spk10: from Raymond James. Please go ahead.
spk12: All right, thanks. Good afternoon. Keith, it sounds like you're confident in profitability and free cash flow, which makes sense. Obviously, the model has proved itself over the years. So I wanted to ask about capital allocation. The balance sheet's already very healthy. You've got a lot of capacity. Right now, the market's pivoting towards Universal, SASE, and SecOps, as you mentioned. Curious how the conversations have gone internally to potentially accelerate your pivot towards that with larger M&As. And conversely, you know, if we look at the after-hours action here, the ROI on share repurchase is looking potentially very strong. You know, the opportunity to potential step-up share repurchases. Just in general, how you're thinking about using the balance sheet as a weapon during a time where the business and stock is pressured? Thanks.
spk02: Yeah, I think we included a comment in my prepared remarks that the available, we still have nine, as of the start of the month, start of the week, I guess, we had $980 million of available authorization for the buyback. And I think you saw some of the numbers that we provided in the prepared remarks about being fairly aggressive during the quarter itself as well in terms of buying back stock. Ken doesn't let me go shopping for companies very often, so I'll defer to him in terms of his thoughts on that.
spk15: We're definitely keeping looking. I think right now the market is probably more reasonable than the last one to two years. Uh, and also we do realize the marketing also changing pretty quick. Uh, we'll continue to the internal innovation. We feel we're the strongest on the internal innovation engineer among all the space player. Uh, but on the same time, uh, we also are open, uh, to looking for some other company, uh, which we can, uh, uh, working together, joined together. Okay.
spk12: And one quick follow-up, just to make sure Peter kicks me off the call next time for this one, but it'll be in the weeds, Keith. Sorry. I want to ask about supply. We've been monitoring inventory commitments. They've been elevated for a little while now. Obviously, demand is deteriorating faster than expected. And we're just trying to think about how to manage inventory and future inventory, given this new state of demand, where that might manifest itself in results. I think you mentioned product gross margin pressured. I wonder if that was related to that. But Any comments on kind of managing this oncoming inventory relative to the current demand? Thanks.
spk02: Yeah, it is related to the inventory levels, and I think we've been managing it for the better part of the second half of this year. And that's some of the commentary that you're getting as we look into 2024 in terms of where the pressure may come from. Any way to quantify it, though? No.
spk15: Yeah, we feel still in a healthy level, and we tend to keep about six months inventory. That's where like when two or three years ago the supply chain issue happened, we are in a market position because also a lot of time our customer needs some urgent delivery of certain products. So we're probably still keeping the similar policy there, but also we're in the refresh cycle of our new product, especially on the low end. I think so far we also kind of re-surprised in the last two or three years Now, since starting to stabilize and start changing from a shortage, maybe more towards even some air oversupply. So, we feel we are in a pretty good position because we more handle this operation manufacturer directly. So, we handle it better than most of our other competitors on the inventory right now.
spk12: Very helpful. Thanks, Ken.
spk15: Yeah, we also don't see a big issue about the current inventory level.
spk00: Thank you. One moment for our next question. Our next question comes from Adam Borg from Stifel.
spk10: Please go ahead.
spk17: Awesome, and thanks so much for taking the questions. Maybe just on the sales execution issues that you talked about in the script, maybe go a little deeper on what exactly happened and a little bit more about the steps you're taking. And maybe just as a follow-up, just on the – SASE partnership with GCP. I know it's obviously just been a couple weeks, but maybe talk about early customer feedback from additional conversations. Thanks so much.
spk15: Yeah, if you look in the last two or three years, we've grown a lot of business, also hired a lot of salespeople. And the last two or three years, we probably doubled the business. And at the same time, during the supply chain issue, somehow certain cells feel kind of too easy to get there because there's always a shortage of certain parts out there. And so that's where we feel we need to enhance the training enablement and at the same time also need to be more disciplined about the performance. At the same time, we also, when we're shifting this to more like a service-based SaaS, see all kinds of consolidation, cross-sell, multi-sell of secure app, the sales also need to keep learning. And at the same time, the marketing need to be kind of more efficient and also kind of a projection to the new growth opportunity. So that's the focus we have right now. So we are definitely keeping looking to be more efficient in both sales and marketing going forward.
spk17: Great. And what about the early feedback on GCP? On Google Cloud. Oh.
spk15: Yeah, it's very good. That gave us a very quick start to match any other competitor on the location a number of locations, a number of pubs, and they also have a lot of broad coverage, so it's a good partnership. And at the same time, we continue to work with some other partners. We also continue to build ourselves, and in the long term, we feel we have more advantage than some of our competitors because we always have a strategy investing in some long-term investment strategy, including some real estate, some other parts. which gives us a much better long-term return.
spk17: Great. Thanks so much.
spk15: Thank you.
spk00: Thank you. One moment for our next question. Our next question comes from Patrick Covile from Scotiabank. Please go ahead.
spk07: All right. Thank you so much for taking my question, Ken, Keith, Peter. My question is about the, I guess, kind of qualitative guidance you guys gave for 2024 billings. If I remember correctly, in the last quarter, it was expect kind of high-teens bidding growth exiting fiscal 24. Was the commentary of this quarter expect double-digit growth exiting 2024?
spk02: I'm not sure I'm following the math here.
spk07: I'm just trying to last quarter you guys gave some kind of forward look for 2024 Billings and if I remember rightly the kind of forward look was expect exiting Billings growth to be in high teens earlier in your kind of prepared remarks there was a comment which was expect double digit growth in the second half I guess are we going from high teens to double digit is that the change yes
spk02: Yeah, and I think that's prudent given what we've just seen in terms of the third quarter performance.
spk07: Okay, very cool. Thank you so much.
spk00: Thank you. One moment for our next question. Our next question comes from Joseph Gallo from Jeffries.
spk10: Please go ahead.
spk03: Thanks for the question. I've got a two-parter, one for each of you. And Keith, as a follow-up to that last question, appreciate the commentary on bottom line floor for 24. Can you just talk about the methodology of top line guidance? Is this a rip the Band-Aid off guide, or what underpins the confidence and visibility in a reacceleration of billings? Is it SASE turning on or just hardware digestion only taking two to three quarters? And then can Given what you're seeing with AI, do you believe adoption of AI workloads eventually shifts workloads back to on-premise and drives a higher need for firewalls long-term? Thanks, guys.
spk02: Yeah, and I wasn't quite sure if the question was about the Q4 guide or the 2024 commentary about numbers.
spk03: More for next year, but both. It has the methodology for your top-line guidance changed following the past two quarters.
spk02: Yeah, I would say that, well, if we just deal with where I'm actually giving guidance for the fourth quarter, Absolutely. I think the assumed close rates, if you will, are dramatic. I think they're the lowest assumed close rates I've seen that I've used in over five years here for context. And they're obviously lower than what I saw and what I used for the first half of the year. You know, I think that I would say there are indicators that the pipeline quality is better in the fourth quarter. But in given light of what we've done for the last two quarters, I don't think I should put much stock in that. So I'm content to just assume a much lower close rate than I have more recently. 2024, not really giving guidance. I think that, again, we're talking about billings here, and I know we're all aware of it, but really focus perhaps more on the impact of backlog and what it did to billings in Q1 of last year and Q2 of last year and how that eased throughout the year. And so you're really going to see comps change. I don't know that we're necessarily assuming a dramatic growth ramp of bookings, if you will, at this early stage for 2024. We do expect it's going to improve as we bring SASE online more successfully and secure operations. But I think it's really part of what you're hearing there is really getting clarity on how the backlog impacted 2023 numbers.
spk15: Yeah, it's a very good, interesting question about the AEI and the security. I have to say... Definitely AI was starting to get into the security very quickly, both by the good guy, bad guy. But in the general AI side, in some degree, the bad guy probably more leveraged some of that one. And the protect side is still more using what we have been doing in the last 10, 20 years, more like a precision AI. and make sure we block the attack but not block any good traffic. But also, the general AI also helps in supporting costs and also helping the security operation. So it's definitely the AI will keep driving the security growth and both in the cloud and also our clients. We do see our clients also Long-term, very healthy growth, especially because convergence of networking to networking security, especially in the enterprise, in the campus environment. And we see that trend will continue to grow well. And our unique advantage, leverage integrated OS, ASIC, will continue to lead in the market and keep getting market share. So, long-term, I don't see any slowdown of these appliances getting into the cybersecurity space.
spk00: Thank you. Thank you. One moment for our next question. Our next question comes from Gray Powell from BTIG.
spk10: Please go ahead.
spk09: All right, great. Thank you for working me in here. I really appreciate it. So maybe a clarification and a follow-up. So you laid out the breakdown for billings or the new breakdown between secure networking, SASE, and SecOps. Did you all talk about the relative growth rates that you're seeing today for each segment? And then within secure networking, is there a way to think about how much of the slowdown you're seeing there is related to the core firewall business versus some of the networking components like switches and access points and stuff that may have been more, that may have benefited more from like supply chain and budget flush and things like that.
spk15: Yeah, actually we do give the market growth for the three segments going forward. And we also believe we're growing faster than the market growth can gain a share in all these three segments. Related to the firewall of FortiGate versus some other AP switch, we do see more headwind in AP switch, for the AP FortiSwitch, because now supply chain issue kind of pretty much over. And so that's probably compared to the firewall, secure networking firewall side.
spk09: All right, that's enough. Thank you very much. Thank you.
spk00: Thank you. One moment for our next question. Our next question comes from Eric Heath from KeyBank Capital Markets.
spk10: Please go ahead.
spk05: Great, thank you, and thanks, Peter, for getting me in here. Keith, just for you, curious how the economics to the top line for Fortinet change when a customer's kind of doing an apples-to-apples switch over from kind of a firewall customer over to a SASE. And then secondarily, with the shift away from firewall, that probably means more of a shift to annualized billing. So curious how you're thinking about duration and that impact to free cash flow going forward. Thanks.
spk02: Yeah, the second one is probably easier. We have such a large footprint right now with the firewall business that it's going to take a while for any significant changes in the SASE buildings if you really think about it coming into and having an impact on our total term. I don't know that we gave the number, but we know that we've come back to a more – we've come down about a month year over year in terms of contract term in 2023 compared to 2021. We went from 28 months roughly last year to about 27 months this year. Maybe I could be off by a month. And you saw the impact on the financials. We've talked about that. One month impacts the billings number. I think it's going to take a while for SASE. As I mentioned, we've already done several hundred SASE deals. We expect to be more successful early on with, one, in SMB spaces, and two, with our install base. So I would imagine that It's going to take a while to really have an impact on free cash flow.
spk15: Yeah, we also will be keeping accelerated training for internal Salesforce, also to our partner for this new SASE second operation, which is a little bit different than the traditional secure networking side. So that we also feel with a huge installation base, we have an SD-WAN firewall which we are leading. We're number one pretty much in all this area. We feel it's a huge potential to upsell, cross-sell the SASE and secure up once the sales force, once the partner get fully trained.
spk00: Thank you.
spk10: At this time, the Q&A session has now ended. I will now turn the call over to Peter Sikowsky for closing remarks.
spk16: Thank you, Antoine. I'd like to thank everyone for joining the call today. Fortinet will be attending investor conferences hosted by Barclays, Steeples, and Wells Fargo during the fourth quarter. As far as the chat webcast links will be posted on the events and presentation section of the Fortinet's investor relations website. If you have any follow-up questions, please feel free to contact me. Have a great rest of your day. Thank you. Bye.
spk10: This concludes today's conference call. Thank you for participating. You may now disconnect.
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