Q3 2022 Fortinet Inc Earnings Call
Fortinet third quarter earnings conference call at this time, all participants are in a listen only mode. After the speaker's presentation, there will be a question and answer session.
To ask a question during the session you will need to press Star one one that's star one one on your telephone and you will then hear an automated message advising you that your hand is raised.
Please be advised that today's conference is being recorded and without further Ado I will now hand, the conference over to your first speaker, Peter sell Koski, Vice President of Investor Relations at Fortinet. Peter. Please go ahead.
Thank you Eric Good afternoon, everyone. This is Peter Koski, Vice President of Investor Relations at Fortinet I am pleased to welcome everyone to our call to discuss Fortinet Cisco results for the third quarter of 2022 speakers on today's call are kenzie, Fortinet 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 web.
Right.
I will begin today's call by providing a high level perspective on our business.
With a review of our.
Our financial and operating results for the third quarter, providing guidance for the fourth quarter and up and updating the full year. We'll then open the call for questions. During the Q&A. We ask 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 will be making forward looking statements and these forward looking statements are subject to risks and uncertainties, which could.
Cause actual results to differ materially from those projected.
Please refer to our SEC filings in particular, the risk factors in our most recent 10-K and Form 10-Q for more information.
Forward looking statements reflect our opinions only as of the date of this presentation and we undertake no obligation and specifically disclaim any obligation to update forward looking statements also all references to financial metrics that we make on today's call are non-GAAP unless stated otherwise our GAAP results in our GAAP to non-GAAP reconciliations are located in our earnings press release and in the presentation.
That accompany today's remarks, both of which are posted on the Investor Relations website.
Getting keith's prepared remarks today for today's earnings call will be posted on the quarterly earnings section of the Investor Relations website immediately following today's call lastly, all references to growth are on a year over year basis, unless noted otherwise I will now turn the call over to Ken.
Thanks Peter.
And to everyone for joining today's call.
Outstanding third quarter 2020 towards result.
Revenue for the quarter growth, so the 3% significantly outpacing the industry growth rate, we believe that customer recognition of the exceptional value proposition, we provided by our high performance for the ASIC technology and illiquid hold the last auction system is driving our ability to take the cyber security market.
Sure.
Product revenue growth was very strong.
1%, extending our position as a quarter revenue leader in the cyber security industry.
Our revenue performance reflect the strong demand we have build over the past 18 months across our security solutions, along with the successful execution of our internal team in managing the supply chain challenges.
Three growth drivers the high tenant sort of environment.
Convergence of security and networking and the consolidation of security functionality and our vendors together with the opportunity to up sell additional securities services to a significant installed base.
Back to drive future growth.
First the <unk>.
Threat landscape.
<unk> continued to expand and evolving targeting company of our size location and industries to counter the threat landscape.
We are implementing unique universal <unk> across a wide range of customers driving triple digit growth for this product and are delivering a comprehensive approach to zero trust that is consistent for any user anywhere any device and supporting today's hybrid.
Workforce.
Okay.
Four years Fortinet has lead strategy around coverage and so I have been working on security.
The total addressable market for networking and security will increase from 54 billion to date to 73 billion in 2026.
<unk> saw accelerate digital transformation.
Substantially reduce our producing costs combining networking monetization with dynamics the acuity that citizens spend every part of our network.
Especially now that mainly company merging <unk> and AMC operation together.
Fortinet is a leading convergence trend with a wide range of technologies, including network firewall segmentation.
Secure SD Wan Ot security and fire achieved in a single operation system, which can be deployed as hardware software cloud and as a service.
Fortinet continues to gain secure SD Wan market sure Asaf <unk> secure SD Wan solution delivers a better security performance and efficiency over mobile edition offerings.
Quarter SD Wan in OTA bookings grow over 45, 75% respectively.
And together accounted for over 25% of total bookings.
We believe we've achieved number one market share SD Wan in the next couple of years.
Today, we announced our 40 gig one south.
Our latest innovation in converging networking and security.
Powered by our new.
<unk>.
<unk> deliver five to 10.
Higher performance.
Cost six major network security functions by consuming 80% less power less competitive solutions.
The lower power consumption was a contributing factor.
2% ranking S&P global corporate sustainability assessment.
Our third growth driver is the consolidation of vendors and the product functionality with 40, <unk> huge computing power advantage.
Yes.
Most accretive function than our competitors to catch up is almost certain key products ranging from endpoint to network to the cloud security.
Fortinet provide our customer with us.
Our accretion while lower the management cost and the total cost of ownership.
Additionally, we are very focused on selling value added security services to a significant customer base.
According to IDC second quarter unit share data Fortinet hold a number one market share position for units shipped and a 43%.
Up 210 basis points.
Yes.
We expect to have reached 50% market share in the next few years.
<unk> leadership position and to the substantial installed base create attractive economy of scale and the opportunity to upsell additional security services.
Before turning the call over to Keith I would like to ascent.
<unk> customers partners and suppliers worldwide for their continued support and hard work.
Alright, Thank you Ken and good afternoon, everyone.
Start with an overview of our strong third quarter performance revenue of 1.15 billion was another quarterly record for Fortinet, increasing 33% year over year, and 12% sequentially, our highest third quarter sequential growth rate in 11 years.
We continue to deliver better than industry average top line growth and generate strong profitability.
Our operating margin exceeded guidance at over 28% driving the adjusted free cash flow margin to 40%.
Our history as a public company has evolved around the rule of 40 measured as the combined total of revenue growth and operating margin impressively.
Impressively the Q3 total came in at over 60.
We continue to see success in our strategy for expanding further into the large enterprise segment.
The number of deals over $1 million increased over 80% to 153 deals.
Total billings value of deals over $1 million more than doubled driven by a record number of deals over $5 million.
And G 2000 bookings increased over 40%.
Our strong third quarter results reflect solid customer demand across both our core and enhanced platform technologies and the exceptional performance of the team in a challenging supply chain environment.
We believe the investments we've made in building our platform and our go to market engine enables our customers' digital transformation journey.
Our platform strategy allows customers to converged networking functionality with security capabilities, while consolidating cyber security products.
Providing security across their entire digital infrastructure, while lowering their operating costs.
Recently, the Forrester wave enterprise firewall report acknowledged the success of our investment strategy play through.
Fortinet is a leader for the first time in its history.
According to Forrester and quote.
Fortinet excels at performance for value and offers a wide array of adjacent services.
Long known for is Bang for the Buck approach to network security Fortinet has built a flexible and capable platform with its flagship product the Florida Gate firewall.
Taking a closer look at the income statement product revenue grew 39%.
Revenue growth for our core and enhanced technology platform products increased 29% to 51% respectively.
The product revenue growth rate accelerated over four points sequentially, especially impressed impressive.
Given that our toughest year over year comparison in over 10 years.
Service revenue was up 28%.
Accelerating three points sequentially.
Driven by strong product revenue growth and seven consecutive quarters of increasing short term deferred revenue growth rates.
Support and related service revenue was up 28%.
Accelerating over two points sequentially to $311 million.
While security subscription service revenue was up 29% accelerating four points sequentially to $370 million.
Total revenue in the Americas increased 34%.
<unk> revenue increased 37% and.
In APAC posted revenue growth of 23%.
Total gross margin at 76, 2% exceeded the high end of our guidance range.
Product gross margin of 61% was up 30 basis points year over year.
Services gross margin of 86, 6% was flat year over year.
But up 70 basis points sequentially.
Operating margin of 28, 3% was up 250 basis points.
Anything from FX and the operating margin leverage that comes with higher revenues.
Shifting to billings billings of $1 4 billion were up 33%.
Representing the sixth consecutive quarter of billings growth in excess of 30%.
Core platform billings were up 27% and accounted for 67% of total billings.
As shown on slide six entry level, Florida gates posted very strong billings growth.
The mix shifting 16 points in their favor driven.
Driven by demand and as we expected improved supply.
Enhanced platform technology billings were up 45% and accounted for 33% of total billings a positive mix shift to three points.
Average contract term was flat year over year at 29 months.
Looking at the statement of cash flow summarized on slides seven and eight free.
Free cash flow was $395 million.
Adjusted free cash flow, which excludes real estate investments was $464 million.
Representing a 40% adjusted free cash flow margin.
Dsos were down five days sequentially, while increasing 12 days year over year to 75 days.
Cash taxes were $69 million capital.
Capital expenditures were $88 million, including 69 million for real estate investments.
We repurchased 10 2 million shares of our common stock for a cost of $500 million.
Bringing the year to date totals to 36 million shares at a total cost of $2 billion.
The remaining repurchase authorization totals $530 million.
Regarding backlog the backlog at the end of the third quarter was up slightly from the end of the prior quarter with Watergate firewalls accounted for just one third of total backlog.
We expect fourth quarter, ending backlog would be relatively consistent with the third quarter backlog.
We are seeing early signs of a transition back to more normalized customer buying behaviors.
Moving to guidance.
The current environment favors afforded at style platform that offers integrated solutions and strong security capabilities at an attractive cost of ownership.
To enhance our ability to capture our share of the large market opportunity. We plan to continue to invest in innovation across our integrated platform offerings.
Now I'd like to review our outlook for the fourth quarter summarized on slide nine.
With respect to the disclaimers regarding forward looking information that Peter provided at the beginning of the call.
And to start as part of the Q4 guidance setting process, we considered several factors including the.
The greater makar greater macro uncertainty today and with it the increased risk of forecasting the timing of certain larger transactions.
The transition to a more normalized customer buying behaviors, which means there is less of an emphasis on ordering to get a place in line.
For comparison in the fourth quarter of 2021.
When supply was tighter backlog increased over $120 million and contributed 49% bookings growth.
And lastly, elevated year earlier top line comparisons that includes certain one time items, adding a couple of points to service revenue growth and fully cycling the <unk> acquisition.
In response, we have slightly widened our topline guidance ranges.
For the fourth quarter, we expect to again reap the rule of 60.
And with that the key metrics include billings in the range of $1 billion $665 million to $1 billion $720 million.
Which at the midpoint represents growth of 30%.
Revenue in the range of $1 billion $275 million to $1 billion $315 million.
Which represents growth of 34%.
non-GAAP gross margin of $75 to 76% non-GAAP operating margin of 30% to 31%.
non-GAAP earnings per share of 38 to 40.
<unk> assumes a share count of between 795 and $805 million.
We expect capital expenditures of $75 to $85 million.
We expect a non-GAAP tax rate of 17%.
For the full year, we expect billings and revenue growth to exceed 30% for the second consecutive year.
Billings in the range of $5 $540 million to $5.595 billion, which at the midpoint represents a 33%.
Revenue in the range of $4 billion $410 million to $4 billion $450 million, which represents growth of 33%.
Perhaps for context, we should note the mid point of these full year billings and revenue growth rates of three points higher than the initial growth rates. We provided in early February . Despite the start of the war in Ukraine in late February significant increases in interest rates and the increasing uncertainty in the macro environment and importantly, full year backlog is expected to be above the February .
Estimate of $350 million.
Total service revenue in the range of $2 $645 million.
The $2 $655 million.
Which represents growth of 27% and apply his full year product revenue growth of 42%.
non-GAAP gross margin of 75% to 76% non-GAAP operating margin of 26% to 27%.
The mid point of year over year increase of 30 basis points.
And again for context, so the midpoint gross and operating margin expectations for 50, and 100 basis points above the February guide respectively.
non-GAAP earnings per share of $1, <unk>, $2, 15, which assumes a share count of between 800 $810 million.
We expect full year capital expenditures of $325 million to $335 million.
Expect our non-GAAP tax rate would be 17%.
We expect cash taxes to be $265 million.
Before wrapping up I'd like to offer some preliminary thoughts on 2023, and our mid term targets on the heels of a very strong set of growth in 2021 and 2022.
We continue to successfully balanced growth and profitability, while investing in longer term innovation and go to market initiatives to fuel future growth.
The strength of our business model includes diversification.
Margins that provide capacity for future investment.
And a rich rich mix of higher margin recurring service revenues.
As we saw in the height of the pandemic the diversification helps mitigate the risk of economic slowdowns.
Specifically in 2020, we delivered operating margins of nearly 27%.
Free cash flow margin of over 38%.
Top line growth of 20%.
And during the past 12 months, we have really exceeded our operating margin target operating margin targets while.
While increasing our engineering head count by about 20% and.
We're significantly increasing our future sales capacity by over 25%.
Including a greater than 50% increase in new non tenured salespeople.
While we will provide more detailed 2023 guidance when we report our fourth quarter results.
It's worth noting that service revenue accounts for 60% of total revenue.
With gross margins hovering above 85%.
We see continued service revenue growth driven by two years of very strong product revenue growth and seven consecutive quarters of accelerating short term deferred revenue growth.
With a strong business model and a history of being able to execute we are confident that our momentum will continue and point to our key growth drivers, including strategic investments the heightened threat environment, the convergence of networking and security cyber security consolidation.
Cyber security, though not immune to economic slowdowns is expected to remain relatively safe Harbor.
That's not true we remain on track to achieve all of our medium term financial targets from our May 2022 analyst day.
Including $10 billion in billings and $8 billion.
And revenue in 2025.
Each representing a 22% three year CAGR from the midpoint of our 2022 guidance.
The targets also include an average non-GAAP operating margin of at least 25% for the four years from 2022 to 2025.
And in 2025, adjusted free cash flow margin in the mid to high 30% range.
Illustrating our long term focus for balancing growth and profitability our targets remain committed to the rule of 40 or better.
I'll now hand, the call back over to Peter to begin the Q&A.
As a reminder, during the Q&A session. We ask you. Please limit yourself to one question and one follow up question.
Key participant Erica we are ready.
Excellent and also as another reminder, if you want to ask a question press Star one one on your telephone and wait for your name to be announced.
Please standby, while we compile the Q&A roster.
And our first question comes from Fatima <unk> at Citi Fatima Your line is open.
Thank you good afternoon I appreciate you taking my questions Keith.
First one for you just with respect to the <unk> guidance and the outlook I appreciate you're kind of breaking down the three principal factors that went into that but I wanted to dig in specifically on the comment you made about normalized buying behavior as it relates to the backlog build so I think what I inferred from your comments is that.
While the backlog is going to be sequentially up in sort of higher than what you initially pointed out to be maybe $350 million ending backlog.
That's certainly below the $500 million.
A free Telegraphing. So I just wanted to better understand sort of the the modulation downward on the backlog there and how then Kevin normalized buying behavior contributes to that and then I'll ask my follow up.
Okay, I think when we talk about normalized buying behavior I think that we certainly saw some enterprise customers in the U S. During the supply chain challenges that were placing orders to get in line.
Hold their place in line for what inventory is available and I think I'll say a year ago or so that that was inappropriate behavior. When there was a lot of uncertainty around the supply chain and maybe they're planning for what they were going to do in 2022.
I think that somewhat in general now and maybe Ken will talk more about this.
I think people are getting the sense that the but certainly we are that the supply chain is a little bit easier to forecast somewhat easier to manage I don't mean by any stretch easy, but I do think it's easier and with that I think youre starting to see the market drift back towards emphasized start to what I would call more traditional buying which is.
They need it they're placing the order.
Also look on the composition of our backlog.
It's only one third of last related to.
And that was the key to platform 40 K.
More than half related to like a solution to AP, which isn't that working equipment.
Which is the kind of impact.
Industry.
In the networking side.
Networking devices tend to be.
Hone is tangible most standard driven so another customer at some point that box of order.
Title pad.
The Pie chart you show in.
And also some of them easily cancel once they kind of got a product. So that's why we feel.
Properly.
Keeping tracking the backlog may not be the best way to forecast the business and we should be more focused on securities and futures in the game.
Specialty drug in the shoe to a service based are huge <unk> installation base.
Thank you and Keith just a clarification on the services revenue trajectory and then more broadly thinking about next year. So we saw the reacceleration this quarter in services revenue. So I'm wondering if you can give us a quick update on how the delayed registration is from earlier in the year and transactions from earlier in the Europe trending and how.
Or we should think about that.
Filtering and flowing into our models for next year. Thank you.
Yes, I think we've been messaging throughout the quarter various conferences that and even in the prior quarter that we had a clear expectation that service revenue growth has accelerated so we're very pleased to see that.
There's a number of things that are providing a tailwind into that customer registering units as part of that I think also the price increases making its way.
First into orders and deferred revenue and now into the income statement.
Keeping in mind that we have contracts that sometimes are as long as five years.
That will give you a sense of how long the tailwind may relate to price increases as we will continue to cycle through renewals at oil prices and replace them with new contracts. So I think we feel good about the direction of the service revenue and the margins that it provides together with the fact that 60% of our business.
Okay. Thank you.
<unk>.
Our next question.
Comes from.
Socket Calia and Barclay socket. Your line is open. Please go ahead.
Okay, great. Thanks, very much for taking my question here.
Keith maybe you can maybe just to start with you I'd love to just zero in on product revenue growth a little bit for this year can you just maybe talk about some of the growth drivers for product revenue. This year that aren't expected to repeat next year again very helpful detail kind of thinking about total billings for.
Kind of following years, but for product I wonder if some of the one off things that we should be keeping in mind like an Alex I'll like like price adjustments just to sort of think about what normalized growth in product might look as we start to think about following the following years.
Yes, I think a lot of Alexa is probably the easiest one to talk about in terms of providing numbers.
<unk> talked about the fact that their revenue stream was probably something on the order of $130 million to $140 million when we acquired them.
It reminded people that they are at March 31 year end, so therefore quarter was a little bit off cycle.
I think that if growth is single digits. So I think that probably gives people a good level of expectation reminder, there that are interested in <unk> is a lot around at VIP and some opportunities that we have there to do things more longer term if you will.
In terms of other unique things about product revenue in the quarter I mean, I think that.
As the backlog comes into revenue.
As we go through the end of 2022 here and certainly into 2023.
We're going to provide again, a fairly significant tailwind to what the product revenue growth will be in 2023, assuming we get the drawdown in backlog.
That we may see.
Also we believe the growth driver, especially the converged network and security.
We don't think and that's a slow down we'll be keeping driving the revenue growth in the next five to 10 years, you can see the the secure SD Wan and OTT.
Both have pretty healthy growth and the same time, we will continue to grow in the next five to 10 years.
Huge.
Huge market potential.
Got it got it maybe for my follow up.
Really for both of you I'll make a jump ball here.
I think in Q3, we had operating margins of about 28% I think the guide for for Q4 is for margins a little bit higher.
That long term guide up to 25 of at least 25% it feels like Youre doing a lot better than that here in the near term. Maybe the question is how do you sort of think about that balance right in terms of in terms of growth maybe.
Maybe moderating a normalizing as we mentioned versus sort of that long term margin.
I think thats, where if you look on.
The 13 year history.
The company, we always balance the growth.
With the margin.
That's why we view the 25% of our Bob It's a healthy margin and then we can also give the money to invest in the growth.
Leader in the space.
That's why we're continuing to balance.
Well slow down definitely will be more helping on the margin. So that's why we keep them safe.
40, probably in the last few quarter, we even reach the rule 600, now so thats, where it also but when that growth slowed down some.
<unk> service revenue has a higher margin, which can also help on the margin, but we do expect.
The growth will continue in the next few years southeast us equals travel I'll mention on the path of additional service revenue.
Big installation pace allowed us not quite both secured a certain channel yet.
Yes, I would probably sort of.
Agree with Kent elaborate just a little more detail on it.
Keeping in mind that our.
We sell in U S dollars.
So theres really not a direct FX impact there on the revenue line, obviously, you can get into certain countries where that.
Pressure on discounting if you will because of exchange rates can be a little more intense.
On the Opex, because 30% of our business in the U S and the rest is international.
We do get a tailwind from Opex from.
The strength of the U S dollar and I think youre seeing that in Q3, and you're seeing that in Q4 and probably why it's important is that we've talked for a number of years now around and made reference to 25% operating margin.
If you go back four years ago, five years ago. It was probably a target to get to 25% operating margin and since then we've talked about averaging 25% setting a floor of 25%.
It has certainly served us well.
A way to help other people understand about how we invest in the business and as Ken makes reference to it as we have funds available over that 25% operating margin it creates opportunities for some not necessarily all that youre seeing currently of those of those margin dollars to be reinvested back in innovation and back into our go to market strategy.
Yes.
Got it very helpful. Thanks.
Okay. We're just lining up the next question.
And the next question comes from Hamzah <unk> at Morgan Stanley Hamzah. Your line is open. Please go ahead.
Hi, Good evening gents. Thank you for taking my question.
Keith.
On the backlog.
I appreciate look sometimes.
You have too many metrics that creates too many noise and.
On the supply chain front it seems like.
It's getting a bit clearer.
But could you give us any more granularity on how that.
Backlog and bookings trajectory looked relative to your guidance, which I think you guided to it you were saying about 36% growth at the midpoint for bookings. So just curious how that shook out in Q3.
Yes, I think I'll come back to the kind of Ken's commentary around backlog, which is really what drives the conversation about bookings I think a year ago. When we introduced the backlog metric there was a lot of uncertainty around what the supply chain crisis was going to look like and how it might impact our business.
And the purpose of providing the backlog disclosure and the booking disclosure then we'll have to kind of round out and help investors understand more about our business model as we go forward and as we heard the question earlier.
One of the questions.
Joining of the year, we're kind of swag that kind of swag backlog growth of $350 million in the first quarter and then it came back and said in the second quarter, maybe it's going to get closer to $500 million for the full year and now I think we're looking at a number that's going to be less than that something in the floors, probably seems reasonable for where we're at and I think the net net the message.
Two messages. So one is yes.
I think we are becoming much more comfortable with our ability to execute in this environment and maybe some easing in the environment itself and then secondly, I think that was always our intention and I think the message. This that these will be short term metrics that we provide.
And I think they have served us and our investors well for an extended period of time, but it's probably time now that we feel that we've gotten a better control on it to bring us more bring us back in line. If you will with what our industry competitors are disclosing and not disclosing.
It makes total sense just to follow up really quickly I mean is it fair to say that Youre still youre bookings growth is still higher than your than your than your billings growth. Obviously your backlog grew so youre still expecting underlying bookings to be higher than 30%. This year.
We're not we're not going down to the detail of parking specifically about bookings as I've just mentioned going forward no more backlog more than what we have given to this point.
Okay. Thank you.
Yes.
Okay. Our next question.
Comes from Rob Owens at Piper Sandler Rob. Your line is open. Please go ahead.
Great. Good evening. Thanks for taking the question just one for me curious with the.
The supply chain getting a little bit easier, how youre thinking about gross margin both kind of in the short term as well as the medium term. Thanks.
Yes.
I think the component and then also the cost continuing to co op.
So thats, where also we still have a pretty tight even 'twenty two.
Most of the shipments shaken by incentive by Ocean.
So that's where we.
When you adjust for that.
How does the cost and probably somewhat of a soft some of them remain.
To some price increase.
It also few.
Even Samsung pricing points, we continue to have.
Price advantage compared to competitive industrial average.
These are all products, so thats, where we are.
The module is <unk>.
<unk> will be more stabilized.
Yes.
That's probably almost a supply of public keeping improving.
Yes.
With that I'd, probably a couple a little more granularity.
I think if you maybe you look at it between product gross margin in services gross margin. The product one is the one that's probably more volatile relate to what we're seeing.
Certainly heard commentary that maybe things are easing a little bit the chip manufacturers, but I will say that there is no indication of any sort of cost reductions or savings that are coming from other chip manufacturers or the component suppliers.
So what we will see how that plays out our strategy has been and kind of alluded to this is that we came into this.
Economic cycle, a year ago, believing that we had a price performance advantage.
And that we could raise prices in our target was really to pass along most but not all of the price increases call it plus or minus 1% margin, it's kind of our target every quarter. It doesn't fall that way every quarter because of various variables.
And I would imagine that to the extent that prices could remain elevated as we move into 2023.
That's kind of a starting point for our pricing strategy into 2023 as well.
Again, because we have not seen signs that we've lost the price performance advantage in fact, we continue to win that way.
Service is a little bit different I mean, the largest cost component and services is labor.
And if you look back we are a company that has this annual merit increases in the first or second month of the year. So you kind of get a rather immediate Joel on the Cogs line from those from the compensation increases which is certainly appropriate.
And then you have to grow the service revenue into it and I think thats part of the conversation about why you saw that.
The reference to sequential margin increases on the revenue side it gets fairly complex.
Well, maybe that complex, but.
Thinking through how price increases that started about a year ago.
<unk> kind of hit a quarterly pace. If you will how those price increases will make their way first onto the balance sheet in deferred revenue and to what extent each each item is going to reflect all of those price increases and then how it will come off the balance sheet in future periods. So you will get tailwind from the price increases and I would expect that that.
That particular tailwind should continue to for an extended period of time.
Ken and Keith Thank you.
Okay.
Our next question just connecting the line now comes from Saul <unk> at Cowen.
Your line is open. Please go ahead.
Thank you so much good afternoon guys.
Question on APAC.
Softest performance and I think Mike too nears, what was driving that and I have follow up.
Yes, I think we've made a leadership change there.
Around the end of June beginning of July we had a retirement.
And I think thats.
Just kind of the transition of leaders. If you will is one was exiting into retirement and we brought somebody on that I think we feel very very good about.
In terms of their ability and I think the other part of it is.
Youll start to see the lapping effect of the <unk> because all of the <unk> sitting in APAC.
So youre going to see that now as we roll up on basically the full quarter comparisons.
That impact.
Understood understood and on 40 gig sales, maybe looking at it from a tiered perspective, it was slightly more mixed than prior quarters inquiry level actually representing most growth versus.
The mid range and high end, so any any color on that Tom.
That's where we see pretty strong growth related to SD Wan and OTC.
You've seen the low end Q&A.
And at the same time, the supply chain improvements half a little bit.
That's where the.
We'll be able to ship more product. Nonetheless, we still have some some backlog in that mid to high end low end has some new comment bye bye.
<unk> done some of that part of that and also.
Better supply chain right now, yes, Tim to talk about this in the past the ability to introduce the new <unk> product.
In the second quarter, we were a little bit hamstrung in Q2, and the beginning of Q3, even back into Q1 really on the low end and I think we kind of messaged, a bit and our conversations over the last quarter or so that we expected low end supply availability to really jump. If you will in the third quarter and we did see that so it's really more of a supply conversation is in some ways.
As much as it is a demand conversation.
Thank you for the color I appreciate it.
Okay were just bringing our next caller lives.
Okay, that's colors stronach caffari at Robert Baird.
Your line is live thank you.
Hello <unk>.
Okay, Let's go to the next.
The next question standby.
Brad Zelnick from Deutsche Bank.
Brad Your line is live.
Thank you so much and thank you for taking the questions.
And Ken just a big picture question for you to start out with you mentioned Fortinet success is in part coming from the industry trend vendor and product consolidation.
Why is fortinet is well positioned as a platform for consolidation and how does this inform your product and corporate development roadmap in terms of the need for even more product breadth to compete with other.
Platform competitors out there that keep adding additional functionality.
I think we have a few unique advantage the first from day one.
For the AC which have a huge company empower increase compared to using traditional CPU.
But also for the AC also working side by side with the CPU. So thats a huge company empowered <unk> compound for the ASIC gave us.
More company in Pos for the foreseeable asked around more function and more security function, including a lot of networking function. So that lots of advantages none of our component of half of that.
So that may cost keeping driving.
Our market share and also the unit shipment I've mentioned.
A 43% of our market share on a unit shipment.
So we'll be keeping that.
Keeping gave us non comp growth going forward.
Because also on them converging our security networking.
Company policy is a modest happens a huge need to plasma.
I'll address the post acute and I won't give function there.
Seven the holding of OLED, while integrate together with more function language secured empower.
So thats also kind of a huge advantage compared to some other competitors, whether they have to use different blade with different function.
They have to load to Samsung.
A different box that you went to the cloud.
Some of our secure computing power there.
And then we also have about 30 different products, mostly home developed and the hemoglobin ultimately well together. So that's also what's helping drive we caught up by the security fabric.
Gartner called a mesh network.
So that's also helping the customer to lower the management cost and total cost of ownership.
How does it swing factor well, keeping driving fortinet better appreciation for the consolidation both on the put out functionality and also some product.
Single band platform strategy.
Ken Thank you for that and it's clearly working very well your strategy.
Maybe Keith just for you.
You've disclosed quite a bit of information so much so that I have a very simple question that I just might have missed but can you just very clearly.
<unk>.
All enterprise part of the business for example.
It actually outgrew the other two parts of the business in the last quarter by it took about a point of mix I think from the other two so I feel healthy.
Good about the business, but just a little cautious about the macro environment as we go forward and how to forecast what's coming from the sales team.
It makes total sense and in line with a lot of other.
Data points that we're all seeing out there.
I guess just maybe.
As you think about what contributes to that.
Is there it doesn't sound like it's anything competitive.
But what are the customer is doing or are they shrinking deal sizes are they just taking more time and sweating out their existing assets.
Any other color on that would be helpful. Thanks.
Yes, I don't think were going to see deal sizes getting smaller.
Because we're moving into the enterprise.
We are more stable.
Stablish there and it was just kind of the same routine over and over the fact that we're growing in the enterprise and again you saw the numbers is going to by itself inquiries our average deal size.
I certainly do feel that Theres caution.
Corporate America and rest of World is probably going through their budgeting cycles right now and looking at what they are planning for not only the end of 2022 and 2023 I think the other aspect of that and again I think this is rather consistent with other comments, we probably heard I don't think it's a good time to really get in a position of forecasting some sort of significant budget flush in the fourth quarter.
If it develops that would be fantastic, but.
I think it's I think prudent is a little bit appropriate here.
It makes total sense to me. Thank you so much for taking my questions.
Thank you.
Thank you Sir.
Next up.
We have <unk> sorry.
Ceramic.
From Robert Baird. Your line is open thank you.
Okay.
<unk> sorry.
At Robert Baird. Your line is open.
Okay.
Okay, we will move on to the next.
Christian please standby.
Tal Leonids at Bank of America Tal Your line is open.
Hi, you've modeling on for Paul.
Just two quick ones for me and I apologize if I didn't mention Cooper, Brian between your earnings right now, but that's it.
D.
Okay very good.
Last quarter, we heard bookings and bookings with a little bit softer than expected this quarter no disclosure on bookings and again apologize. If this was already mentioned, but.
From your perspective directly wine of bookings for the quarter after a weaker quarter of bookings last quarter.
Yes, we've tackled linker just before you jump in on the call.
For everybody's benefit I'll, just quickly kind of go through it I think when we got into this conversation a year ago, we felt the backlog, which is really the driver of the bookings conversation was something that was we thought it was important to investors to understand and be able to track.
How were performing as a business and what they're seeing in the drivers as we move forward I think that if you fast forward a year later I think we feel more comfortable now about some of the backlog forecasting in.
Earlier, and we made referenced.
Backlog may exit the year, something closer to 400 or a little bit north of that.
And so with that in mind, I think we're bringing ourselves back into what I would call industry norms, where nobody else really disclose this information, but we thought it was appropriate for the first year.
I would also offer one comment about backlog that's important and we've got a lot of conversations around cancellation rates. Our cancellation rate has been extremely consistent at about 4% each and every quarter.
Also the compensation of backlog, it's a ton of different now compared to one year to go which is why.
One year ago.
The same.
Related to the <unk>, now 40 days or less and less started off the whole backlog.
The majority of the backlogs magic compound are switching to AEP.
<unk>, which is also kind of a more industry problem, which.
Switching more easily.
Kosmos and changing different vendor.
For the security product they have to design you may have to.
As a reminder, high switching cost.
So thats why with you.
The backlog sometimes unpredictable.
Whereas the majority of our compounds switch in AP.
Got it thanks, so much and just one follow up question now Kieran I know you guys with Minsheng hovering a little bit of a prudent or.
Going into next year and your guidance I'm also just wondering on the visibility side are you seeing less visibility. The same visibility can you just talk to the trends that youre seeing there in your pipeline.
I think the pipeline visibility is very good and the pipeline growth is very strong.
And I think that one of the things that we did at the end of the prepared remarks was we went back to the 20 to the midterm guidance numbers that we gave.
$10 billion of booking company in 2025, and $8 million in revenue and margins at 25% or more and basically reiterated that and I think we're doing that.
Which requires a 22% CAGR from this point forward.
We're doing that material would be after looking at our pipeline looking at the strength of our pipeline so that it makes sense to us.
Got it thanks, so much.
Okay getting ready for our next caller.
Our next caller is Keith Bachman at BMO Keith Your line is open. Please go ahead.
Many thanks I also had two Keith to start with you I wanted to go back to.
The billings commentary for Q4.
Just so on the revenue base is essentially the same and therefore to Dr. <unk>.
Impact that youre guiding lower.
As you mentioned that Youre expecting.
Backlog to be less than the $500 million in maybe four four and change did some of that backlog is it actually then flowing into the billings and therefore, the billings guide down is even a little bit worse.
And then it actually appears.
And any other context, you could draw allowed on where specifically.
That billings weakness is it Europe or what have you, but if you could flesh those out then I had a follow up for Ken. Please.
Yes, I wanted to be clear, we are expecting backlog to actually increase from Q3 to Q4 not significantly but slightly.
So.
So therefore, none of that backlog then is flowing into that billings in Q as anticipated right.
Correct, I mean, youre always going to get some existing backlog that flows into buildings, but youre going to get new backlog net net it's going to be it's going to be an add in total to it.
For the year and I think the.
It's a good question about Europe , I don't want to.
So without your performance you saw the revenue numbers.
While we don't disclose it I would say the billings numbers youre performed very very well in the quarter.
And our pipeline remains extremely strong as we go forward now we will see as we get through and get closer to 'twenty three.
And I certainly would rarely agree that there are certain tailwind.
Appropriate for Europe , but at this point they've done very very well.
Okay, Ken per unit and it relates to that very directly relates as we think about it.
Europe in calendar year.
'twenty three the currency as you alluded to is a headwind. So I was just in Europe and customers view that the prices since you price in dollars have actually gone up quite a bit.
So is there a risk or how should we think about is there a risk of prices actually needing to come down because of the dollar based pricing and therefore the.
Significant price increase if you will felt by the Europeans is there a risk that prices need to come specifically down for currency next year and or would you see any risk more broadly, whether it's currency or otherwise whereby because supply and demand is coming back into balance sometime during the <unk> 23.
That there is some risk rather than getting price increases that we might be in a situation where prices actually start to move lower.
I think first about our price policy is ready we.
Cost increases led components I'm under we do like.
Some.
Let me take some ourself.
And then some module, we probably have to pass through the customer partner, but even with.
And that capacity, we still lead in the industry on the price performance on.
And the function out of service.
So that's where so far we don't see we lost deals because of pricing.
And actually keeping gaining market share because we have a leading price performance, especially in light of what we call. The convergence area and also skewed by OTR. There is a lot of our fast growing area. So it's all a price advantage.
Compared to competitors and also we do see a lot of potential to clarify additional surveys because our service charge.
Probably average about half of our some of our competitors charging some of the alpha <unk> with China last some of them sell it as a bundle. So we do see a lot of potential growth area service, which also have a higher margin.
Okay.
Okay. Thank you.
Okay.
Yeah.
Okay, just pulling up our next caller and it's Gregg Moskowitz from Mizuho.
Greg. Please go ahead your line is open.
Okay. Thank you for taking the questions.
Keith I know that you had experienced a bit of a pause in the first 10 days of June with that in mind, how was linearity in Q3 period, where there any air pockets or anything that you would call out.
Yes, I don't think we didn't see anything like we saw the good question, we didn't see anything like the two week pause or 10 day pause we saw the first.
Part of June .
In the Q3 I think that.
When we look at linearity you can see the Dsos and I think that's a pretty good reflection of where we're at with linearity.
It has not been probably will never be a one third one third one third business in terms of linearity youre always going to get about 50% of your business in the final month of the quarter, but nothing nothing really unusual about.
The activity there.
Okay. Thanks, and then just as a follow up we're getting quite a few questions about that billings guidance that Q4, you outlines earlier too.
In response to Brad's question.
Calculate if that's sort of going into the Q4 guidance and.
<unk> with respect to the possibility for.
Our sales cycles too to be elongated I did just want to be fair, though on that on that point as it relates to the Q3 period and perhaps even the month of October are you seeing any changes as it relates to average sales cycles.
We still have a lot of strong pipeline actually stronger than before and the same time, we do a pretty healthy strong sales capacity to meet demand Keith mentioned some tenure.
We have about 50% of Salesforce actually.
Paul.
<unk> yet.
But even then it become more productive in the next six to 12 months, which also will help drive both the top line bottom line.
And just so I don't know if you can because I've already done that for 10 years up about 50% of people.
We didn't have we given the mixed number but it runs about 30% of the mix. So it's a significant number of people that we increase that theres fairly new to the organization.
And then it'll make sense I'm just wondering if there were any changes perhaps.
He noticed that where it might've been macro related affecting sales cycles over the past three to four months or so with its possible. It could be very helpful to get a brief commentary on that as well. Thank you.
I, just think that as I said earlier in the conversation as we started to see some our deal size is getting larger and the enterprise. We are certainly subject to more inspection, perhaps than we will.
The eight figure deals are certainly much more inspection and the fight in the seven figure deals were.
Yes, Okay makes sense thanks, guys.
Standby for our next question.
Adam Tindle Raymond James has our next caller Adam Your line is open. Please go ahead.
Okay. Thanks, good afternoon Keith.
Wanted to start I appreciate that you gave a little bit of color on 2023 on services growth acceleration, obviously, an exciting catalysts I think the flip side of that is we're just kind of really unsure how to think about puts and takes to the other line item on product revenue growth.
I'm not asking obviously for specific guidance, but I'm thinking about these tough comps you just had.
<unk> had very strong growth on one of the toughest comps that you've ever experienced in Q3 your exit rate billings as guidance is coming down I think just worried that the cancellation rates are at 4%, but could that ultimately increase with supply chain visibility. So a lot of fear.
On how bad product revenue growth could ultimately be uncertainty on services revenue growth. So anything you could maybe point us to for a realistic view of how to think about puts and takes the product revenue growth and 23.
Yes.
Some old ground here and I don't think that negatively.
I would just again, the fact that we reiterated our midterm guidance, which was a 22% CAGR is probably a good indicator of how we think about it I think that.
<unk> and analysts and ourselves we're trying to understand.
The timing of when the backlog is going to reverse.
I actually go through the income statement and have an impact from product revenue.
Yes, and it is going to provide when it does happen I think I will provide some elevated product revenue numbers.
As we look forward to it.
Yes.
Another point to that when I kind of lost my train of thought I apologize.
Yes.
The growth driver, we view has not changed unlike the convergence Michael the consolidation also elevate Microsoft environment.
That's all we're keeping driving.
The product growth and also the service also I think the product revenues, you'll need a leading indicator of service revenue.
Strong product revenue growth in the last two or three as we do see the service revenue continue to improve.
Yes.
Come back and just talk a little bit about the cancellation rate comment that concern again it has been.
Remarkably consistent at 4% not suggesting there's something there that would be a challenge.
And certainly I think the the firewall part of that which is roughly one third is probably very specific to us, but not really a commodity there's other metrics that we provided in the past and we can start to kind of go through them again over 90% to 95% of all backlog is with existing customers.
That is actually there's people coming off the street trying to order from us because they are trying to double order or something like that that's just not plausible about it and what's in backlog I think again over 50%.
I'm looking at Peter Nodding, along with he agrees with me there has been partially delivered so it's unlikely theyre going to cancel something though.
Backlog got older you know do we do we have more concerns about it and we watch the aging of a little bit yes, we did but now we're starting to see.
Have a plateau here in terms of what the backlog increases are sort of some easing around tends to be on the horizon around the supply chain environment. So.
While we do watch the cancellation rates very very closely we are not seeing indicators of concern there, yes, I think one other stat I think that's right.
Im recalling the numbers correctly.
But I think the top 20 deals in backlog accounts are like 8% of that lineup. That's what it was.
Got it maybe I can sneak in a quick follow up just to get all the fear out there because you know aftermarket move suggests there's a lot of fear.
On.
From a billings basis youre mixing towards larger deals, which is obviously a good thing for the business, but your average contract term is flat at 29 months.
A number of software companies are seeing durations decline and in particular on those large multi year deals. How do you think about potentially controlling for this so that duration doesn't become a headwind to billings growth. Thanks.
Yes, I think as we continue to we've said for several years, but as we continue to expand in the into the enterprise segment.
We expect that that's going to bring with the longer term contracts and it has shown that if you go back a couple of years I think average contract rates were closer to $24 25 months and Youre seeing that.
That continued pressure.
Absolutely continue to believe that as we continue to have success expanding the enterprise and that can print continues to be a larger part of our business. It will continue to put a bit of a tailwind. If you will on average contract term I think also SD Wan as shown.
Clearly be.
Longer term contracts that when customers come to the party. So we're not we're not seeing that I'm happy to see the last few quarters that we've kind of hinted at 28, 9% month.
And staying at that level I was actually concerned that it was going to continue to grow and get into the low <unk>.
Thank you.
Okay.
Okay. We have our last question for this session.
Michael <unk> at Keybanc. Your line is open Michael Thanks, So to the extent you can can you talk about whether or not it seems realistic.
Backlog to continue to rise after this quarter or is that the point you think that starts to go down.
At a fundamental level, where do you think we are relative to demand and if you will a refresh cycle around data centers.
Been neglected.
The incumbents.
Probably we're not using the refresh.
Because that field in the last like cut.
A couple of years.
Is it some changes in the in network security landscape.
Using the convergence.
Especially we see the strong growth from secure SD Wan <unk> and also internal segmentation data Center security.
Thank you restarting keep pointing toward a position traditional network security not as.
Deployed.
Thanks.
Most of the growth from that area, we do get into some big enterprise.
So look and how to do.
So the consolidation.
Now working security and working with the other part of <unk>.
Infrastructure security there.
We also see strong growth.
Falcon is in that bigger enterprise there also.
Probably not as high as where are they at the point of a new area.
And not only the environment, there's a lot of our costs and also a lot of like the working from home remotely.
But also a lot of new clients.
Non of a new deployment, so that's where probably would not would not kind of looking to refresh we replacing some other owned.
Our security rights, but it's more in the new area, we see it will be gradual growth or wireline time that next five to 10 years.
And Keith on the backlog.
I'm sorry on backlog.
Yes.
Yes.
Yes.
I think the last quarter and then maybe what are the kind of fourth quarter. It would the inference would be that were a bit of a plateau.
Still going to depend on supply there, which is still a dynamic.
Thanks.
Okay. At this time I would like to turn it back to Peter sell Koski, Vice President of Investor Relations for closing remarks Peter.
Eric I'd like to thank everyone for joining today's call Fortinet will be attending investor conferences hosted by Barclays Stifel and Wells Fargo during the fourth quarter webcast.
Webcast link will be posted on the events and presentation section of our web site you have any follow up questions. Please and presentation.
Thank you very much.
Yeah.
And this concludes our program you may now disconnect. Thank you.
The conference will begin shortly to raise your hand during Q&A you can dial star one one.
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