Aaron Ovadia:

Thank you and good afternoon, everyone. This is Aaron Ovadia, Director of Investor Relations at Fortinet. I am pleased to welcome everyone to our call to discuss Fortinet's financial results for the second quarter of 2024. Joining me on today's call are Ken Xie, Fortinet's Founder, Chairman and CEO; Keith Jensen, our CFO; and John Whittle, our COO. 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 then review our financial and operating results Second quarter of 2024, before providing guidance for the third quarter of 2024 and updating the full year. We will then open the call for questions. During the Q&A session, we ask that you please limit yourself to one question and before we begin, I'd like to remind everyone that is on today's call that we will be making forward-looking statements and these forward-looking statements are subject to risks and uncertainties which could cause actual results to differ materially from those projected. Please refer to our SEC filings and in particular, the risk factors in our most recent Form 10-K and Form 10-Q for more information. All forward-looking statements reflect our opinions only as of the date of this presentation and we undertake no obligation and specifically disclaim any obligation to update forward-looking statements. Also, all references to financial metrics that we make on today's call are non-GAAP, unless stated otherwise. Our GAAP results and GAAP to non-GAAP reconciliations are located in our earnings press release and the presentation accompanying today's remarks, both of which are posted on our Investor Relations website. The prepared remarks for today's earnings call will be posted on the quarterly earnings section of our Investor Relations with 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.

Keith Jensen:

Thank you, Ken and thank you, Aaron and good afternoon, everyone. Let's start with the key highlights from the second quarter. Overall, we are very pleased with our execution in the quarter. We achieved record growth in operating margins at 81.5% and 35.1%, respectively, while delivering top line numbers at the high end of our guidance range. Revenue grew 11% as product revenue exceeded our expectations, driven by robust software revenue growth and sequential hardware growth that more closely aligned with historical norms. We also added 6,300 new logos as we continue to invest in our channel partners. As you'll hear in a moment, we believe we are on a pace for another rule of 40 year. At the same time, we accelerated our investments in the fast-growing Unified SASE and security operation markets with the acquisitions of Lacework and Next DLP. Lacework strengthens our position in the high-growth CGNAT market and expands our total addressable market by $10 billion, while Next DLP improves our position in the stand-alone enterprise data loss prevention market. Combined, Fortinet will gain over 900 customers and talented sales and engineering teams. And I'll just pause here to offer a very warm welcome to team members from both companies. Continuing with our Q2 highlights, we've taken the lead in partnering with the U.S. Cybersecurity and Infrastructure Security Agency, or CISA through a secure by design pledge and are leading with our responsible transparency practices. We want to emphasize, we understand customer trust is paramount to our business. Our continued success across all customer segments in each of our 3 pillars, represents hundreds of thousands of end customers testing and buying for net security solutions. Simply stated, this is a significant scale advantage and a responsibility a few others have and also offers customers validation at a very robust level. We are committed to responsible updates and deployment processes supply chain controls, product security measures and transparency. To understand more about the proactive measures we take to safeguard our customers and our reputation, please visit our trust website at fortinet.com/trust. Looking at billings in more detail. Total billings were consistent year-over-year at $1.54 billion, overcoming the headwind from the drawdown in backlog in the comparable quarter. At the same time, total bookings increased year-over-year and more importantly, the sequential growth rate approached pre-COVID, pre-supply chain norms. Unified SASE and SecOps delivered strong growth along with software while product sales recovered more than expected. We continue to see significant progress from our investments in both pillars and saw strong pipeline growth of 45% for Unified SASE and 18% for SecOps. Both pillars are gaining significant momentum within our installed base is over 90% of Unified SASE and SecOps billings are coming from existing customers. Larger enterprises continue to be our largest customer segment. with large and mid-enterprises combining to represent 86% and 82% of Unified SASE and SecOp solutions, respectively. Within Unified SASE, 40 SASE buildings continue to grow at triple-digit rates as existing customers can seamlessly integrate our solution within minutes to secure their hybrid workforce. While 40 client customers are able to use a single agent to secure Internet, private and SaaS applications. We've also integrated 40 AP with 40 SASE for securing thin edges and unmanaged devices. Our Unified SASE solution continues to gain market recognition. For the second consecutive year, we've been recognized as a challenger in the Gartner Magic Quadrant for single vendor SASE with the third highest placement in the ability to execute access. And as mentioned earlier, we are further improving our FortiSASE solution by adding powerful data loss prevention capabilities from Next DLP. Rounding out the billings commentary, the SMB was again the top performing customer segment, while international emerging was again our best-performing geography. On an industry vertical basis, technology and transportation grew at double-digit rates, while service provider and manufacturing were more challenged. Turning to revenue and margins. Total revenue grew 11% and to $1.434 billion, driven by service revenue growth and software licenses. Service revenue of $982 million grew 20%, accounting for 68.5% of total revenue. Service revenue growth was led by 36% growth in SecOps and 27% growth in Unified SASE. As noted on Slide 5, Unified SASE includes SASE and related technologies together with SD-WAN. Product revenue decreased 4% but better than expected to $452 million. Excluding the impact of backlog, product sales growth improved 14 points quarter-over-quarter and a similar amount year-over-year. Software license revenue growth continued to accelerate at 26% and represented a high teens percentage of product revenue, a nearly 5-point increase in the software mix year-over-year. Combined revenue from software licenses and software services such as cloud and SaaS security solutions, increased 32%, accelerating from 23% a year ago and providing an annual revenue run rate of over $800 million. Total gross margin increased 360 basis points to a quarterly record of 81.5% and exceeded the high end of our guidance range by 400 basis points, benefiting from higher product and services gross margin as well as a 5-point mix shift to higher-margin service revenues. Product gross margin of 66% increased 250 basis points year-over-year, mainly due to increased software mix and lower indirect costs. On a quarter-over-quarter basis, product gross margin increased from 56% to 66% as hardware demand increased and inventory levels and related inventory charges moved closer to historical norms. Service gross margin of 88.6%, increased 240 basis points as service revenue growth outpaced labor cost increases and benefited from the mix shift towards higher-margin FortiGuard Security subscription services. Operating margin increased 820 basis points to a quarterly record of 35.1% and was 840 basis points above the high end of our guidance range, reflecting the record gross margin as well as cost efficiencies within the business. Looking at the statement of cash flows summarized on Slides 16 and 17. Free cash flow was $319 million for the quarter and $927 million for the first half of 2024, or $1.1 billion after adjusting for real estate and infrastructure investments. Cash taxes in the quarter were $252 million. As a reminder, last year's second quarter benefited from the deferral of approximately $190 million in cash tax payments which were ultimately paid in the fourth quarter of 2023. Infrastructure investments totaled $23 million. Average contract term in the second quarter was 28 months, flat year-over-year and up 1 month quarter-over-quarter. DSO decreased 7 days year-over-year and increased 2 days quarter-over-quarter to 68 days. While we did not repurchase shares in Q2, share buybacks have totaled $5.3 billion over the last 4 plus years and the remaining buyback authorization is $1 billion. Now, I'd like to share a few significant wins from the second quarter. In a 7-figure deal, an international government agency purchased 12 solutions across all 3 pillars, including 8 SecOp solutions. This new customer selected Fortinet because of our operating system's ability to consolidate over 30 networking and security functions into a single unified platform, covering SecOps, SASE and Secure Networking. The customer was impressed with the integrated security, end-to-end visibility and automated response features of our FortiOS operating system. Next, in a 7-figure win, a large utility company, expanded our partnership by signing their first enterprise agreement with us to safeguard their OT environment. This deal displaces 5 legacy vendors and includes ruggedized equipment deployed to the customers' power plants, control centers and substations. Keys to this expansion win were our proven expertise in securing critical infrastructure and our price for performance advantage. And lastly, in a competitive displacement win, our retail store chain purchased our FortiSASE solution in a 7-figure deal. This customer chose Fortinet because of our integrated FortiOS platform, as they were able to seamlessly integrate FortiSASE with their existing Fortinet security solutions. Now I'd like to offer some comments on customer inventory digestion and the firewall refresh cycle. Last quarter, we pointed to a 25% improvement in the number of days of registered FortiGuard contracts from its peak and view this as an early but soft indicator of that "inventory digestion" at end users appear to be normalizing and the firewall market could start to show signs of recovery. To provide an update on this indicator and other signs of possible improvement in the firewall market, we can share that as shown on Slide 19, in the second quarter. The days of registered security service contracts improved another 12 days and has now returned to 2020 pre-supply chain, pre-COVID crisis levels. Inventory commitments and levels are normalizing at our contract manufacturers and in the channel. And as noted earlier, the sequential increase in hardware sales in the second quarter aligned more closely with historical norms. While these indicators are positive, we believe customers are currently managing a tough macro environment and a key election year in the U.S. and we believe this is having an impact on our customers' purchasing decisions. As a result, we believe a full refresh cycle is unlikely to occur in 2024 but more likely in 2025. Moving on to guidance. As a reminder, our third quarter and full year outlook which are summarized on Slides 21 and 22, it's subject to the disclaimers regarding forward-looking information that Aaron provided at the beginning of the call. Before reviewing the outlook, I'd like to offer a few modeling notes in light of our Lacework and Next DLP acquisitions, covering estimates included in our Q3 and full year guidance. For billings, the acquisitions increased Q3 by approximately 0.5 point and the full year by approximately 1/3 point. Total revenue increased Q3 and full year growth by 1 point and 1.5 points, respectively. For gross margin, they decreased Q3 and full year margins by less than 0.5 point for each period. For operating margin, they decreased Q3 and full year margins by 3 points and 1.5 points, respectively. Inclusive of these acquisition-related estimates, for the third quarter, we expect billings in the range of $1.530 billion to $1.600 billion which at the midpoint represents growth of 5%, revenue in the range of $1.445 billion to $1.505 billion which at the midpoint represents growth of 10.5%. Non-GAAP gross margin of 79% to 80%. Non-GAAP operating margin of 30.5% to 31.5%. Non-GAAP earnings per share of $0.56 to $0.58 which assumes a share count of between $767 million and $777 million. Capital expenditures of $40 million to $60 million. A non-GAAP tax rate of 17%. And cash taxes of $125 million to $145 million. And again, for the full year, inclusive of the numbers we gave a moment ago, we expect billings in the range of $6.400 billion to $6.600 billion; revenue in the range of $5.800 billion to $5.900 billion which at the midpoint represents growth of 10%. Service revenue remained of $3.975 billion to $4.025 billion which at the midpoint represents growth of 18%. Non-GAAP gross margin of 79% to 80%, Non-GAAP operating margin of 30% to 31.5%. Non-GAAP earnings per share of $2.13 to $2.19 which assumes a share count of between 767 million and 777 million. Capital expenditures of $320 million to $360 million. Non-GAAP tax rate of 17% and cash taxes of between $525 million and $575 million. I look forward to updating you on our progress in coming quarters. Before we begin the Q&A session, it is with deep sadness that we recognize the passing of our friend, Peter Salkowski, our SVP of Finance and Investor Relations. Peter was an integral part of the Fortinet team for over 6 years and was renowned for is passion for mentoring and developing the next generation of leaders. We'll miss Peter and fondly remember his commitment to fostering talent and nurturing potential within our company. I know that Peter worked closely with many of you on this call and the outlining of condolences and heartfelt memories you've shared since his passing clearly shows the positive impact he had on so many people's lives. Peter took great pride in his contribution to Fortinet and rightly so. having contributed to increasing shareholder value from $8 billion to $46 billion during his tenure Fortinet. We'll miss Peter. Aaron, back to you.

Operator:

[Operator Instructions] Our first question comes from the line of Brian Essex of JPMorgan.

Keith Jensen:

Yes. I think the gross margin is the largest driver of what you saw in the operating margin, particularly when you look at it on a quarter-over-quarter basis and in that, we talked about or made reference to a more normalized environment for us in terms of inventory levels, turns and what we're seeing with channel inventory but also commitments to our contract manufacturers. So I think that we've been working through that for probably the last 3 quarters, maybe 4 quarters. And with that, I would say, I think we've returned to a more normal state and so I would expect that to continue on. I think we're getting a little more contribution from sales and marketing than maybe I'd like at the moment and I would expect us to make a little bit more investments there as we go through the second half of the year. Keep in mind, we're getting a very large group of salespeople as Ken made reference to from both the Lacework and the Next DLP acquisitions. But I think we feel certainly comfortable with the guidance that we've given for both Q3 and for the full year on the margin line.

Keith Jensen:

Yes. I don't -- I mean, I think it's a good starting point is to look at the improvement in operating margin flowing through to free cash flow. Some of the changes that we monitor would be things like contract duration but you've seen now that industries and companies have been talking about contract duration for several quarters and you really haven't seen that come through to us yet. I should say, yes, habits going to come through to us. And so I'm not I think we have opportunity to leverage our balance sheet more with our customers and prospects that we have. But I don't see over the next 90 days or 180 days, a dramatic shift in that area.

Hamza Fodderwala:

I'll echo my condolences for Peter and his family, we'll definitely miss them. Keith, I wanted to follow up on the margin question because obviously, it was a very strong beat, I think a lot more than any of us were expecting historically, Fortinet has kind of managed the business towards the 25%-plus type operating margin run rate. I'm curious, is this the new base that we should sort of think Fortinet goes off of longer term? Or is it sort of a onetime margin outperformance given what you saw on the gross margin side coming out of the inventory digestion headwinds?

Ken Xie:

Also, we'll benefit from the service revenue which has a much higher margin compared to the product revenue. So once the product starts growing, because product has a lower gross margin, that probably will impact the margin but the product is also the leading indicator of future service. So that's where we kind of also were happy to see the product also starting growing now which I think going forward with the product has a higher percentage, that probably also will impact the margin.

Fatima Boolani:

I wanted to share my condolences for Peter, he was just a fantastic person and he will absolutely be missed. Keith, I wanted to zero-in on your comments regarding software license growth. You talked about that accelerating 26% year-on-year, I believe and now it constitutes a high-teens percentage of your product revenue, I wanted to understand what are the drivers behind that massive mix shift and how we should think about the trajectory of this mix shift in the context of your guidance for the remainder of the year and bringing into consideration some of the hardware digestion, potential prolonging comments that you shared as well, if you can help us square that away?

Ken Xie:

In the FortiSASE and FortiOS, we see customers setting turn around more and more function which also enable more service for us. At the same time, the FortiSASE Secure Ops has also fully pretty much our service base and plus a lot of secure a high percentage in software compared to the hardware on the secure networking part. So that's both helping drive the additional software and licensing growth.

Gabriela Borges:

Either for Ken or for Keith. On the firewall refresh cycle, I can appreciate your comments on not expecting to see a recovery in 2024. Share us a little bit more detail on why you think we'll see it in 2025. And -- to what extent are customers giving you an indication that they will be refreshing in 2025, perhaps as we get through the election and some of the macro or perhaps because of their updated depreciation plans? Any color on why you think the timing will be 2025 would be helpful.

Operator:

Our next question comes from the line of Tal Liani of Bank of America.

Keith Jensen:

Tal, I think I kind of missed -- very, very faint on your questions there. Maybe if you can give us maybe a little later recap of the 2 questions you had.

Keith Jensen:

Yes. I think that -- I mean if you kind of look at the recap of the year, there's not a lot of variability in it, if you will. We are a little bit light in the first quarter, we came back and recovered the first quarter shortage in the second quarter. Now you see us looking at the third quarter and maybe taking that just a little bit off of some of the Street numbers and looking to see a little bit of that back in the fourth quarter. But we're kind of taking the third quarter correction to the Street numbers and putting it into the full year number. But yes, offsetting a very, very similar amount in terms of what we expect to get from the acquisitions and that leaves the full year range very much intact. And I understand that tick up is quick, I understand part of that is I'm taking -- I'm getting inorganic benefit in that number of the 0.5 point that we talked about at the -- and really taking down the organic part of the business. But again, I think we're talking about small numbers here.

Keith Jensen:

Yes. I think the OpEx is probably a little lighter on the sales and marketing line than maybe we would like to see, particularly as we start looking at more opportunities as we get into the second half of the year and into 2025. So hopefully, we'll find some opportunities there to make investments. Obviously, you're going to get a fairly significant movement there from the 2 acquisitions that we just did and we gave the number about what the OpEx impact is going to be, that will largely be in sales and marketing. Buyback, I think that we still remain being opportunistic and that opportunistic number changes every 90 days as we reset our plans.

Operator:

Our next question comes from the line of Rob Owens of Piper Sandler.

Keith Jensen:

Yes. I think because we are so diversified, as you kind of alluded to, 70% of the business is international and a little bit less than 30% in the U.S. And yes, there's been a lot of elections around the world this year but it's certainly the U.S. election, maybe weighing on people and every kind of taking a position of waiting to see. As you move -- pull back from that, the international emerging part of the business has been strong, very strong for several quarters and continues on to be. A lot of those are oil-producing countries and similar. So I think they've done well in this economic cycle. There are a little more risk there perhaps with geopolitical events in some of those countries. But to this point, it really hasn't had an impact there. We are much more likely to be the number 1 market share when you move outside the U.S. and parts of Europe and the Middle East and Latin America and parts of APAC. And I think having an incumbency advantage, if you will, helps you in those more challenging times because you're there, you're on site and you have that opportunity to cross-sell and upsell your installed base.

Rob Owens:

And Keith, if you contemplate these acquisitions and a little bit of mix shift to software and I realize hardware is weak right now with the potential recovery next year. But how are you thinking about billings duration? You shave some off the back half and I think some of that's probably the mix shift towards software as we kind of look overall at the model and the increase in revenue but as we contemplate 2025, how should we think about billings duration and potential compression with more cloud-based or software deals that are likely shorter in nature?

Operator:

Our next question comes from the line of Shaul Eyal of TD Cowen.

Ken Xie:

We do believe next year, there's -- I think first, overall, we see the long-term convergence -- networking convergence to network security, we're still keeping going. That's why we do give the CAGR in secure networking area is about 15% year-over-year growth. If you look in the investor presentation slide for about which page. But on the other side, we also see a lot of new opportunity, whether in the OT area in the Unified SASE and also upsell, cross-sell which are all helping driving, I would say, probably like a 90% customer initially moved by a FortiGate getting the firewall and network security market first which we have a huge advantage over competitors. But after that one, they're keeping expanding beyond the network security, go to the other area. So that's what's happening for the Unified SASE for the Secure Op. And now the product, especially on the FortiGate firewall side we're starting to see kind of go back to normal or starting growing with the market now. So, we do feel probably next year will be whether the refresh cycle which after -- that's where the existing customer, if they have the product for 4, 5 years, that's probably the average turn starting to refresh. And so we do see probably next year, we're starting that process.

Brad Zelnick:

Keith, I think you called out the service provider segment is more challenged this quarter after being a strong performer last quarter. And I know it's lumpy and remains a top vertical as it always has been for Fortinet. But can you share an update on what's happening in that segment? And in particular, how your value prop and unified -- and focus on Unified SASE and SecOps applies in this important vertical?

Keith Jensen:

Yes, Ken is spot on, right? It's a lumpy industry. Financial services can be to at times as well. But I think more importantly, I think the conversations around their own independent SASE solution that they can bring to market is something that's getting a lot more conversation from the service providers. I think we saw it first internationally and we're starting to see a little bit more of it here domestically. But that's going to -- that's a pretty exciting opportunity if it continues to move forward.

Keith Jensen:

Yes. I think there's a few things going on there. I think probably 9 months ago, we looked at the cost structure pretty closely. And across a number of areas. And the first place that people kind of look at and when you're in that vote is marketing programs and they get hit pretty hard early on. And I think you're trying to see that roll through you do make changes to your compensation programs, whether it's for direct salespeople or for channel people or what have you. And I think maybe as we're coming out of that environment now, it's important for us to kind of revisit some of those decisions and making sure I kind of talk about the investment opportunities that we have in the sales and marketing line. And I think I would include the channel net as well. It is why I would say that to your point or you're repeating me, probably a little bit lower than we would have liked it to have been in the second quarter. And I think we'll continue to make go-to-market investments here in the second half of the year.

Operator:

Our next question comes from the line of Adam Tindle of Raymond James.

Ken Xie:

I think we have not increased the price in the last few quarters. I think that because we still believe we have a huge advantage with FortiASIC, FortiOS technology has a more function better performance, lower total cost of ownership and also energy cost. So we feel we're keeping that advantage over our competitors. On the other side, we don't see any pressure to also decrease price all kind of discount more. So that's where we feel we're keeping pretty stable for the price. And at the same time, that the customers see the benefit of our product solution and with better performance, more function which also will drive the future service. I think the bigger environment also, we don't feel changed much. Definitely, we see that the inventory all go back to normal weather on kind of inventory and also the channel inventory. That's also more helping driving the healthy behavior in the business also in the supply chain area. Maybe Keith has something to add.

Operator:

Our next question comes from the line of Adam Borg of Stifel.

John Whittle:

This is John Whittle. There's a lot of positivity around that. We obviously just announced it today, we closed it yesterday. We did a lot of diligence on the company, The tech is great. And not only will we plan to offer it stand-alone but also integrated with our FortiSASE solution. And so I think it's another step in steadily bolstering our FortiSASE solution, We feel very, very confident in our strategy there. For the most part, as you know, I mean, we've done some tech and talent tuck-ins. Most of our technology is organic I think to some of the earlier questions, you think about the firewall market coming back next year. And we really just started kind of organizing our solutions into these 3 pillars less than a year ago and the amount of progress we've made and the execution we've made in kind of developing very, very competitive solutions in SASE and SecOps in addition to secure networking is pretty impressive. And I think this is an important step along the way to continue to develop the best SASE solution out there to protect our customers.

John Whittle:

Sorry, the sales execution with SASE and SecOps.

John Whittle:

Yes. No, it's a really good question. I think what we're seeing is it does take time. We are very focused on that broad sales enablement I always say, I mean, the opportunity just abounds from our solution set and we're always with a customer-first focus. So in terms of protecting and serving our customers the opportunity to bounce I think our sales force -- the good news is they have a ton of opportunity. I always say they're going to suffer more from indigestion than starvation. But we've got really a big focus in the company to really train up that sales force, enable that sales force, make sure we have the incentives in the right place and make sure we have the support. So when they do qualify different opportunities in different solution sets, the support to support them in that sale. So I think, like Keith had alluded to, we often land with the firewall and then expand and get that support to our sales force with SASE and SecOps solutions and we're seeing a lot of success there.

Saket Kalia:

Tip my cap to Peter as well. We're going to miss him. Ken, maybe just to start with you. I wanted to get into just the firewall refresh for next year a little bit. I mean you've seen so many refresh cycles over the years. How would you sort of compare this upcoming cycle versus others in the past? And maybe touch on how SASE and sort of -- maybe what sounds like a higher mix of virtual might sort of play into that?

Saket Kalia:

That makes a lot of sense. Keith, if I could fit in one quick follow-up. Just on the software mix in product, I think you said, call it, roughly $800 million run rate. Can we just touch on, even anecdotally, roughly how much of that is sort of virtual firewall versus SecOps? And I realize they're coming in at software gross margins. But can you put a finer point on that and sort of what that aggregate business might be coming in at from a gross margin perspective as we think about that gross margin shift long term?

Operator:

Our next question comes from the line of Joseph Gallo from Jefferies.

Keith Jensen:

No, great question. I mean we've talked about 8-figure deals and our size 8-figure deals can kind of still will around, as you saw in the fourth quarter last year, we did 6 of them. We had one 8-figure deal, Q1. We had 2 in Q2. So I would wouldn't attribute to that. I think what we saw the last month of the quarter and particularly as we got into the last week of the quarter, what you see in a strong market is a lot of deals started to fall in place and we're getting across the finish line. I think we saw a lot more positiveness if you will, at the end of Q2 than maybe we saw say at the end of Q3 or something like that last year.

Keith Jensen:

Yes. I don't think that the form factor really impacts the visibility in terms of what's in the pipeline or how we work with the sales teams in terms of forecasting. I've not noticed a difference, if you will, in close rates between a virtual machine and a physical machine.

Operator:

This concludes the question-and-answer session. I would now like to turn it back to Aaron Ovadia, Director of Investor Relations.

Operator:

Thank you for your participation in today's conference. This does conclude the program. You may now disconnect.

Ken Xie:

Thank you, Peter, and thank you to everyone for joining our call. Q1, we've managed business with strong spending discipline and increased our operation margin 200 basis points to a first quarter record of 28.5%. We also generated record cash flow from operations of $830 million, and our adjusted free cash flow margin was 61%.

Keith Jensen:

Thank you, Ken, and good afternoon, everyone. Let's start with the key highlights from the first quarter. As Ken mentioned, we continue to manage the business through the macro uncertainty and successfully drove operating margin to a first quarter record of 28.5%, exceeding the high end of the guidance range by 200 basis points.

Peter Salkowski:

Thank you, Keith. [Operator Instructions] Operator, please open up the line for questions.

Hamza Fodderwala:

Perhaps both for Ken and Keith, you spoke to a lot of green shoots in your prepared remarks. SMB service provider growth looks a little healthier. You're getting a recognition on SASE, and you spoke to competitive replacements.

Keith Jensen:

Yes, I'll talk about the full year. I think that if you look at where we ended up in the first quarter, inside the guidance range, maybe just a little bit of weakness that we saw in Europe, just enough to move us off the midpoint, but not really a big movement in terms of where we are in our final results compared to the midpoint.

Operator:

Our next question is from Gabriela Borges of Goldman Sachs.

Ken Xie:

I think our price strategy is pretty consistent in the last 20-plus years. We want to maintain a healthy gross margin and also a healthy margin for the partners. And when we see certain cost increase like doing the supply chain shortage, whether the component costs or some shipping costs increase, we kind of increase the price. But now some of the costs coming down, we also kind of returned some margin to the partner and also low on product price to match the pre-pandemic level.

Operator:

Our next question comes from Brian Essex from JPMorgan.

Ken Xie:

I think that's a great question. I think we have a slide for that.

Brian Essex:

Okay. Great. Maybe just as a quick follow-up on that topic. I think you mentioned, if I'm not mistaken, Unified SASE 81% of -- I'm sorry, SD-WAN, 81% of Unified SASE billings. And I think you might have given that metric to back into SD-WAN last quarter, if you could maybe iterate what that was?

Ken Xie:

Yes. And also, we build SD-WAN function into the FortiOS, which, whenever you have a FortiCare, we believe like close to 60%, 70% customer all have by the FortiCare, they have automatic SD-WAN function. And so that's where we do see other SD-WAN, current SD-WAN customer, which we were not fully tracking because the part of our [ list function free ] of charge. So we do believe a lot of them are [ interest ] come into SASE for SASE function there.

Fatima Boolani:

Keith, I wanted to -- have you spent a little bit of more time talking about some of the geographic theater-level performances. So we've seen a pretty material deceleration in your Americas business. EMEA has been relatively resilient and APAC's actually shrunk this quarter. So I was hoping you could put a lens on each one of those geographies to talk about any nuances or idiosyncrasies from a demand and/or buying perspective from an end market standpoint or a customer attribution standpoint. And then just a follow-up with regards to if you can talk about the pipeline and pipeline growth you're seeing with secure SD-WAN proper, considering that is such an important conduit for future SASE upsells.

Ken Xie:

Yes. Also, Japan probably kind of about is the biggest country for us in APAC and probably 1/3 of more APAC, which the currency like the U.S. currency pretty strong again. Japan currency is that may also have some impact of some slowdown there. On the other side, we do see most SD-WAN customers definitely more interest in the SASE and also in the current environment, more and more customer set in terms SD-WAN because SD-WAN definitely have been a cost saving. So on average, it's about 50% in cost savings compared to the traditional NPI or other networking function there. So we do see more and more customer first converting to SD-WAN customer and then using the same FortiGate adding additional SASE function there.

Tal Liani:

You gave some comments at the end of your prepared remarks about signs of recovery of the firewall market? And would you mind to repeat that? You went over quickly in -- the question is also with it, do you expect the non-FortiGate to recover? Is there a correlation between the two? Do you expect the non-FortiGate to recover? And -- or does it have its own cycle.

Keith Jensen:

Do you want to take the market share and the mix, and then I'll go through the algebra on Slide 19.

Tal Liani:

Got it. And what about the question on non-FortiGate. What are the cycles within non-FortiGate on the FortiGate side?

Ken Xie:

The notice probably around 10% of our product, that's probably -- all the networking side, definitely down a little bit, but there's some other like whether the FortiWeb, FortiMail some other we see for we see pretty strong growth. So it's a mix. But overall, I think pretty much similar like the FortiGate mix. But definitely, we see it.

Operator:

Our next question is from Rob Owens of Piper Sandler.

Operator:

Our next question is from Saket Kalia of Barclays.

Ken Xie:

Yes. The 3 parts of the business. One, like Keith mentioned, is really the digestion whatever supply chain issue. I think that's pretty much over, maybe just a few more months, it will be all normal. And the second part is really the refresh, which is the current customer over the new product, which has a better performance, all the things there. I have to say, seeing the economy slowdown or high interest rate environment, some customer may stretch the current product a little bit longer.

Ken Xie:

We have not seen any pricing pressure discount because we tend to be much better performance and more function because of ASIC technology and none of our competitor has. On the other side, [ billion ] customer considered a new function they needed for security or higher network speed environment, I think compare us to some competitor because competitors sometimes they just cannot keep in function like all the SD-WAN function in their existing firewall for us is very, very different.

Brad Zelnick:

And because we just had 2 for Ken, I think I'm going to now go for 2 with Keith, if we could. Keith, first one, I think, pretty straightforward with $1 billion left in your buyback authorization and the strong cash generation of the business, I was surprised to see and not buy back any stock in the quarter. Can you just remind us of your approach to buybacks and if any change in thinking around use of cash and specifically M&A?

Brad Zelnick:

And maybe just my follow-up. I'm sorry, please.

John Whittle:

Yes. We see a lot of opportunities in the securities base for sure. And so yes, we build a pipeline just like sales build the pipeline, and we consider them as they come along and reach out on product as well.

John Whittle:

If I can, we're going to say something on hire.

Keith Jensen:

Yes. I think the -- setting aside the fact that need more resources in finance, but I was hoping Ken was just going to announce that, but that's probably not. The -- I think the business model, Brad, you've seen it through the cycles where -- if you look back at 2017, for example, and if you look at the gross margin number, when you start to see the slowdown of the pause, the cycle and the hardware, you start to see the mix shift to the really rich services. .

Operator:

Our next question comes from Ben Bollin of Cleveland Research Company.

Keith Jensen:

No, I don't think there's really a change. I think there's always a few puts and takes, if you will. I think the real driver was that last quarter, we had those 6 8-figure deals, and I believe all those closed in the last week or 2 of the quarter. So that put a lot of pressure on DSOs and only having one 8-figure deal this quarter, which I believe closed fairly early in the quarter, in mid-quarter, but not in the last week. So I think that's really all I would point to there.

Keith Jensen:

Yes. I think when you say partners, I would say that all the large distributors that we're working with are offering financing programs, either in some cases, it might be through their own captive. But I think more often not, it's white labeling somebody else's product, if you will. I think that also some of the larger resellers are also offering financing.

Operator:

Our next question comes from Adam Borg of Stifel.

Ken Xie:

Yes, I think we do see when we have a more enterprise customer and they also want to be long-term customers and also with many different products like the consolidation strategy they have right now, we see more EA. And at the same time, with that one, we definitely see kind of a bigger deal and also kind of a more long-term customer can be with us right now.

Adam Borg:

That's great. And maybe just as a quick follow-up. In the slide deck, I didn't recall seeing the breakout of the FortiGate by small, medium and large. I know that indicator has been less meaningful more recently. I was just curious, is anything interesting there as you think about the FortiGate sales by size?

Operator:

Our next question comes from Keith Bachman of BMO.

Ken Xie:

And I think since we only launched our own FortiSASE six months ago, we see pretty strong growth but also SD-WAN has been there for a few years. So I have to say, probably most -- a majority if not the most, SASE still more comes from SD-WAN, which is in the chart there. Maybe the better way to say is really look at the pipeline, so that's on key script. He said -- it's a Unified SASE probably pipeline grow like 45%. And then the SSE pipeline growth over 150%. That's maybe a better indicator as a pretty strong for the SASE interest and also leverage our both SD-WAN and the firewall market-leading position there.

Joseph Gallo:

A lot of cool stuff around AI at your conference. FortiAI, any early feedback? And how are we thinking about monetizing that? And any impact to gross margins? And when can that benefit top line?

Keith Jensen:

Yes, I think it's some more tactical responses to you. In general, we're charging for it separately. It's on the price list. It's additive to it, and you're going to really push my technical knowledge, maybe somebody here can eat me out. But I think there's an LLM the customer has to go out and buy on their own, in some cases, to enable it. And then I would offer a really shameless plug. I really tell you, you should go look at our website and see the demo that was done at Accelerate with FortiAI, it was fantastic.

Ken Xie:

I think probably if I look back to 20, 30 years when there's a big attack in the space, then they drive some kind of a new function, then there's some rush by something maybe impact some of them. Otherwise, it's pretty normal, I don't know, 7, 8 [ week ] whatever a customer to register. And then the last 2, 3 years, the supply chain really changing sometimes certain channel partners on the distributor may try to have a little bit more inventory.

Keith Jensen:

Yes. And I think the charts actually goes all the way back to 2019. And you can see it by quarter there. Nothing jumps out of me in terms of seasonality by quarter that we really have that I would call out to it. So...

Peter Salkowski:

Thank you, Brianna. I'd like to thank everyone for joining today's call. Fortinet will be attending investor conferences hosted by JPMorgan and Bank of America during the second quarter. Fireside chat -- website link -- webcast link will be posted on the Events and Presentations section of our 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 very much.

Peter Salkowski:

Hey viewers, good afternoon, everyone. This is Peter Salkowski, Senior Vice President of Finance and Investor Relations at Fortinet. I'm pleased to welcome everyone to our call to discuss Fortinet's financial results for the fourth quarter of 2023. Joining me on today's call are Ken Xie, Fortinet's Founder, Chairman and CEO; Keith Jensen, our Chief Financial Officer and John Whittle, our Chief Operating Officer. This is a live call that will be available for replay via webcast on our Investor options website. Ken will begin our call today by providing a high-level perspective on our business. Keith will then review our financial and operating results for the full year and the fourth quarter of 2023 before providing guidance for the first quarter of 2024 and the full year. We'll then open the call for questions. [Operator Instructions]. Before we begin, I'd like to remind everyone that on today's call, we will be making forward-looking statements and these forward-looking statements are subject to risks and uncertainties which could cause actual results to differ materially from those projected. Please refer to our SEC filings, in particular, the risk factors in our most recent Form 10-K and Form 10-Q for more information. All forward-looking statements reflect our opinions only as of the date of this presentation and we undertake no obligation and specifically disclaim any obligation to update forward-looking statements. Also, all references to financial metrics that we make 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 remarks, both of which are posted on the Investor Relations website. The prepared remarks for today’s earnings call will be posted on the quarterly earnings section of our Investor Relations website immediately following the call. Lastly, I'll reference to growth are on a year-over-year basis unless noted otherwise. I will now turn the call over to Ken.

Keith Jensen:

Thank you, Ken, and good afternoon, everyone. As Ken mentioned, billings grew 8.5%, driven by improved sales execution and early returns on our SASE and SecOp investments. The quarter benefited from what we saw as a muted seasonal budget flush and certain deals that had pushed from earlier quarters, closing in the fourth quarter, driving a record six transactions, each of which were over $10 million. For these exceptionally large transactions, secure networking was 75% of the billings mix, while SecOps and SASE combined for another 20% plus, illustrating these companies' long-term commitment to both firewall and consolidation strategies. Taking a closer look at three of these eight-figure deals, one of these deals included mid-seven figures for SecOps and another mid-seven figures for SASE. The SASE solution covers a planned 350,000 user deployment at a top U.S. school district to provide a safe learning environment for students, regardless of their physical location. We won this deal because of our operating system's ability to integrate 30-plus networking and security functions across SecOps, SASE, and secure networking into a single, unified platform, providing consistent policies and automated responses. Our vision encompasses creating a secure foundation for our customers, allowing them to navigate today's evolving digital landscape with confidence while empowering them to embrace innovation without compromising security. Illustrating this vision, in another eight-figure deal, a large U.S. enterprise selected Fortinet to support their hybrid cloud architecture as they transition more of their workloads to the cloud. This competitive displacement reduced complexity and the customers' total cost of ownership while showcasing our ability to consolidate security functions onto our FortiOS platform. In a third eight-figure win, a large financial institution in the U.S. expanded their partnership with us with their first enterprise agreement with Fortinet. This EA includes the recently announced FortiGate Rugged 70G to secure their remote working and ATM environments. Built with AI-powered security, the Rugged 70G brings our customers the latest secure networking innovations while at the same time simplifying infrastructure and driving efficiencies. In addition to exceeding the customer's performance expectations in a multi-vendor bake-off, we were successful by demonstrating the versatility of our single operating system and FortiOS platform across multiple use cases. Over the past several years, we have successfully addressed large customer buying preferences by increasing our investments in EA programs. In the fourth quarter, these contracts represented nearly 10% of our billings, with a three-year CAGR of over 80%. Today, with over 35% of our billings beyond traditional and sometimes cyclical firewalls, Fortinet has become an increasingly diversified business over the past decade. Most recently, the diversification has included prioritizing investments in SASE, SecOps, and other software and cloud-based solutions. A key element of this diversification is our single operating system strategy. FortiOS is the foundation of our comprehensive and innovative solutions that drive the convergence of networking and security while also consolidating multiple security capabilities. Attempting to piece together best-of-breed solutions from multiple vendors can result in significant security gaps, slower AI-driven technology adoption, and a slower pace of identifying, reporting, and resolving security incidents. Organizations increasingly recognize that an integrated security solution run by a single operating system is the best way to improve their security posture. Consolidation allows security solutions to share data and communicate with each other, reducing complexity, improving security effectiveness, easing the need for skilled labor, and lowering the total cost of ownership. Consolidation drove our SecOps business to 44% growth, with strong growth from EDR, SIEM, email security, and NDR. Importantly, 94% of our SecOps business was from existing customers, as companies looked to execute their vendor consolidation strategy with Fortinet. Digging a little deeper into the 11% of billings that SecOps contributed to our business, the mid-enterprise segment is growing the fastest as these companies respond to the cybersecurity labor shortage and look to reduce complexity. Geographically, international emerging is leading the way for SecOps, likely reflecting stronger economic conditions and extending the success of their 2022 pilot project. Extending the single operating system and consolidation strategy further, our single vendor SASE solution, billings increased 19% and accounted for 21% of total billings. Our SASE pipeline is up over 150% as more of our sales reps are building pipeline. As expected, the SMB segment was the largest mix of SASE customers at 55%, increasing eight points quarter-over-quarter. Fortinet has one of the least complex and most customer-friendly SASE pricing models. Our one bundle and one operating system solution provides all the standard capabilities, including secure web gateway and firewall as a service for secure internet access, Zero Trust Network Access and SD-WAN from our points of presence, providing secure private access, as well as CASB and data loss protection. Our single vendor SASE solution also includes integration to SOC as a service and FortiClient, which provides a customer with endpoint protection and vulnerability scanning. Regarding our focus and investments in SASE and SecOps, SD-WAN customers represented 37% of new SASE customers. Over 90% of our global sales force has completed mandatory sales training for both SASE and SecOps. In 2023, 60,000 customers and partners attended at least one of our 27 training workshops. Lastly, we've increased our worldwide points of presence coverage to over 150 locations. Turning now to the quarterly financial results, total billings were $1.86 billion, up 8.5%, driven by improved sales execution and a strong rebound in the large enterprise segment, together with 6,400 new logos. On a billings-by-geo basis, the U.S. led the way with mid-teens growth driven by strong performance in the U.S. enterprise. In terms of industry verticals, government and financial services, each with growth of approximately 25% were our top two industry verticals, while service provider and retail remained under pressure. The average contract term was 30 months, up two months year-over-year and sequentially. Adjusting for the six eight-figure deals, the normalized contract term was consistent year-over-year and sequentially at 28 months. Turning to revenue and margins, total revenue grew 10% to $1.42 billion, driven by strong services revenue growth. Service revenue of $927 million grew 25%, accounting for 66% of total revenue, a mixed shift of eight points. Service revenue growth was driven by strength in SecOps, SASE, and other security subscriptions. Product bookings were up, however product revenue decreased 10% to $488 million due to a tough compare. Product revenue grew 43% in the prior year period, benefiting from the drawdown of backlog. Total gross margin of 78.5% was up 90 basis points and exceeded the high end of the guidance range by 200 basis points, driven by the increase in service gross margin and the eight-point mixed shift from product revenue to service revenue. Service gross margins were up 140 basis points as service revenue growth outpaced labor costs and benefited from the mixed shift towards higher margin security subscription services. Product gross margins were down 510 basis points as we continued to see margin pressure related to inventory levels and product transitions. Operating margin was very strong at 32%, three and a half points above the high end of our guidance range and operating income of $454 million was $40 million above the high end of the implied guidance range, reflecting aggressive cost management. Looking to the state of the cash flow, summarized on slides 17 and 19, total cash taxes paid in the quarter were $341 million. Including $210 million estimated tax payments that were deferred from earlier quarters in accordance with U.S. and California one-time regulatory relief, resulting in free cash flow of $165 million. Capital expenditures were $27 million. We repurchased approximately 16.8 million shares at a cost of $895 million for an average cost per share of $53.29. Moving to an overview of our 2023 full year results, billing surpassed the $6 billion mark, totaling $6.4 billion and up 14%. Total revenue grew 20% to $5.3 billion, and we added over 25,000 new customers. Service revenue grew 28% to $3.4 billion, driven by a 33% increase in security subscriptions. Product revenue grew 8% to $1.9 billion, on a very tough compare after going 42% in 2022. Gross margin was up 110 basis points to 77.4%, benefiting from the revenue mix shift to service revenue. Operating margin also increased 110 basis points to a calendar year record of 28.4%, resulting in operating income of $1.5 billion. The GAAP operating margin of over 23% continues to be one of the highest in the industry. Earnings per share increased 37% to $1.63. Free cash flow was a record at over $1.7 billion. Free cash flow margin was 33%. Including real estate investments, the adjusted free cash flow margin came in at 35%. For the year, we repurchased approximately 20 million shares at a cost of $1.5 billion, for an average cost per share of $55.25. And to summarize on slide 20, Fortinet has returned $5.3 billion to shareholders via share repurchases in the past three years. Earlier this year, the board increased the share repurchase authorization by an additional $500 million, bringing our remaining share repurchase authorization to approximately $1 billion. Moving on to guidance. As we look to 2024, several factors impact guidance, including the firewall industry cycle, remnants of 2022 and 2023 supply chain activity, and customer buying behavior. Prior firewall product life cycles have lasted approximately four years, with eight quarters of higher growth followed by eight quarters of slower growth. Looking at our bookings, the current product cycle decline started approximately four quarters ago in Q1 of 2023, suggesting that we should experience the bottom of the cycle in early 2024.suggesting that we should experience the bottom of the cycle in early 2024. Worldwide supply chain challenges resulted in elevated purchasing and record backlog, distorting year-over-year growth comparisons, and creating a period of project and product digestion. The backlog drawdown in the first half of 2023 provided a mid-to-high single-digit percentage tailwind to billings and low double-digit tailwind to product revenue growth for that period. The year-over-year product revenue comparisons in the first half of 2024 will be the most challenged, while we expect service revenues to grow sequentially in the low single digits in the first quarter and to grow sequentially at low to mid-single digits for the remainder of 2024. In addition, we expect product revenue growth will continue to be impacted by project and product digestion in 2024, and we believe the selling environment should improve in the second half of 2024 and into 2025. As a reminder, our first quarter and full year outlook, which are summarized on slides 23 and 24, subject to the disclaimers regarding forward-looking information that Peter provided at the beginning of the call. For the first quarter, we expect billings in the range of $1.390 billion to $1.450 billion, which at the midpoint represents a decline of 5.5%, revenue in the range of $1.300 billion to $1.360 billion, which at the midpoint represents growth of 5.4%. Non-GAAP gross margin of 76.5% to 77.5%, non-GAAP operating margin of 25.5% to 26.5%, non-GAAP earnings per share of $0.37 to $0.39, which assumes a share count of between $775 million and $785 million. Capital expenditures of $220 million to $250 million including a real estate transaction that closed earlier in the quarter. A non-GAAP tax rate of 17%, and cash taxes of $30 million. For the full year, we expect billings in the range of $6.400 billion to $6.600 billion, revenue in the range of $5.715 billion to $5.815 billion, which at the midpoint represents growth of 9%. Service revenue in the range of $3.920 billion to $3.970 billion, which at the midpoint represents growth of 17%. Non-GAAP gross margin of 76% to 78%, non-GAAP operating margin of 25.5% to 27.5%, non-GAAP earnings per share of $1.65 to $1.70, which assumes a share count of between $785 million and $795 million. Capital expenditures of $370 million to $420 million, non-GAAP tax rate of 17%, and cash taxes of $520 million. I look forward to updating you on our progress in the coming quarters, and I'll now hand the call back over to Peter to begin the Q&A session.

Operator:

[Operator Instructions] Our first question comes from the line of Fatima Boolani with Citi.

Keith Jensen:

Yes, I think kind of going backwards in terms of the very large deals that we talked about, I think experience has showed us in the second half or the middle part of last year that we're well served not to get too far ahead of ourselves in terms of forecasting those deals. And it's difficult to understand when they're actually going to close and what the specific terms are going to be with those. So I think we kind of set those aside, and you saw that in some of the performance in the fourth quarter. In terms of margins, I think that sometimes the business model is easier than people think it is when it comes to margin because services provide so much of the business. If the business model is two-thirds services and it's throwing out a very rich margin, even in a period of time where you're going through the firewall refresh cycle, you're still seeing your margins hold up fairly nicely. I think there's also significant economies of scale involved in the services line, whether it's the support or the security subscriptions. And then the last thing I would offer is that I think the breadth of both the SecOps Solutions and the SASE Solutions together are serving to spread some of the incremental costs for the hosting solutions and bringing those to market.

Hamza Fodderwala:

Good evening. Thank you for taking my question. Ken, over the last several years, we've seen some pretty significant increases in network traffic, whether it be more cloud adoption, more work from home, etcetera, and that's led to pretty healthy firewall refresh over the last several years. I'm curious, and I know it's very early innings, but how do you see sort of the adoption of generative AI, particularly in some of these hybrid contexts, impacting network traffic going forward? And do you think that that's going to incent more firewall refresh to secure that growing network traffic? Thank you.

Hamza Fodderwala:

Thank you.

Operator:

Our next question will come from the line of Brian Essex with JPMorgan. Brian, your line is now open.

Ken Xie:

I think you probably can recall in the last earnings call, we started more focus on SASE SecureOps and started tracking that separately. And also, we also mentioned 90% of our field sales force also being trained certified for SASE SecureOps. And also, all the six eight-figure deals, including all the three, secure networking, SASE and the SecureOps. So, we do see it grow faster, especially during the current kind of environment of refresh cycle. We do see the SASE, which is more consumption model, and also SecureOps, which can lower the operation cost probably faster than the traditional secure networking area. So that's where we kind of redirect some focus, resource, more focus on these two areas. We see a pretty huge success, grow both the pipeline and also even the deal. We closed some of the first eight figure SASE deal, which also makes us feel pretty excited. I think we have some advantage, actually, leverage the SD-WAN huge deployment we have, all the firewalls, huge deployment, and also the single OS-based SASE solution, which integrates all the SD-WAN, all the SASE functions into a single FortiOS, which is a huge advantage for whether the customer themself or even for some service provider, offer the SASE service to their customer base. So it's a pretty strong growth. We see it's a pretty good move we have.

Brian Essex:

Got it. That's really helpful. We'll keep it to one and keep it efficient, but thank you so much, both of you. Appreciate it.

Tal Liani:

Hi, guys. I'll ask two questions together. It's easier. CapEx is going up materially next year, this year. What is the outlook for free cash flow margin? What happens to free cash flow this year? Can you actually drill down to the CapEx? What drives the increase? And then what happens to free cash flow margin? The second question I have is on the business. This quarter, billings were supposed to be weak, but they're very strong. Next quarter, we expected roughly 5%, 6% declines, and that's what you're guiding to. So that means maybe there was some pull forward, but kind of in line-is. What happens this quarter that billings is so strong versus expectations? What drove the strength? And why don't we see it continue into the next quarter? Thanks.

Ken Xie:

Also, we kind of own probably a high percentage of some infrastructure, some real estate, and some of our competitors. That actually gave us much lower cost, operation cost going forward, which also will help drive the future growth, especially on a service like a SASE. And that also gives us a better margin long-term.

Keith Jensen:

Well, obviously, there's a lot of levers that come into free cash flow. I think that where we look at in terms of where the street was for free cash flow in 2024 for the full year, I think that's in the ballpark at this early stage. We don't really guide to free cash flow, as you know. But I think the puts and takes, one is CapEx, which is not all that far away from what we saw in 2023. But then you have the operating profits, the buildings throughout, etcetera. You know all the components that go into it.

Operator:

Thank you. Our next question will come from the line of Gabriela Borges with Goldman Sachs.

Ken Xie:

S&B is pretty interesting. We do quite well in the SMB market, even for the traditional firewall, bigger than any other competitors. But also SMB has a pretty low percentage of a customer actually using any network security because of whether the management costs or some other people cost, all these kinds of things. So that's where SASE applied there, definitely helping some SMB customers. But also we see kind of the long-term combined both where to work from home, we're pretty strong like a couple years ago in the retail branch office solution there, also helping us kind of like doing well in SMB. And also the new product refresh, which leveraged SP5, we're only half the way, probably towards the second half of this year, we have more product come in using the new SP5. That's also keeping a hands-up position there. It's kind of like I said, it's a SASE more kind of consumption model. In a current environment, probably it would be more attractive compared to a CapEx model. So that's where we see both SMB enterprise, they do have some more interest to do this kind of OpEx model. Maybe John Whittle.

Gabriela Borges:

Thank you for the color.

Saket Kalia:

Okay, great. Hey, guys, thanks for taking my questions here and well done. Keith, maybe for you, I just want to talk about the shape of billings a little bit here in 2024. I think at the midpoint for this year, billings is about 2%, give or take at the midpoint. How should we sort of think about the exit rate on billings this year? I know that was something we talked about in prior quarters. I'm not sure if that's something that we could just revisit. And then maybe relatedly, it was great to get the segment detail, by the way, across the three segments. How are we sort of thinking about the rough growth ranges for those three segments as part of this guide?

Saket Kalia:

It was just on the three segments, right, secure networking, SASE, and SecOps. It was helpful to get sort of the growth ranges for this quarter. Not going to hold you to it, but how do you think about sort of the relative growth rates for those three segments this year?

Ken Xie:

Yes, for the three segments, I don't have the latest market data, but from Q3, the firewall market is kind of flat here. Q4, we probably will read out company reporting. But we do see probably still under some pressure this year, especially the first half of this year. But I do believe the long-term converging story will hold quite well because the company also needs to manage the kind of application level, which is how to use network security to do that. So that's where long-term we do see the firewall market or the network security market will continue to grow, I feel, probably around 10% year-over-year in the next maybe three to five years. SASE and SecOps come from maybe smaller base, which also grow faster. And we also have a lot of existing customers. I want to adopt all this together with us. They probably already are firewall customers, D1 customers. They can easily adopt additional solutions, additional products. So that's where we see the other two sectors grow faster than the company average and probably continue to grow faster in the next few quarters.

Operator:

Thank you. Our next question will come from the line of Andrew Nowinski with Wells Fargo.

Ken Xie:

Yes, the SecOps is actually helping customers more like better security and more efficient and also lower the total management costs. That's where I need to have multiple solutions, multiple products integrated together, automated together. So that's what we see in the current environment of our company. And because small, they do see the SecOps already. The area they probably work on the investment there. And also we do see the merging of networking and security together, which also SecOps plays a quite important role to make sure the two operations can be operated together, which we are needing in this area. So that's where SecOps, we see pretty strong growth. SASE is more like consumption model. We also see kind of fit the current environment well. Even the cost could be a little bit higher than the appliance. But it gives the customer flexibility. And so that's where we see that. John, you want to answer?

Operator:

Thank you. Our next question will come from the line of Brad Zelnick with Deutsche Bank.

John Whittle:

Thanks for the question. I'm really excited about the role. I've been working here for 17 years through a lot of growth, and my focus over those 17 years has really been learning from Ken and Michael and the team. And it's like an MBA on steroids. They're brilliant business people in addition to focusing on the innovation and the technology, which I think is a core differentiator for Fortinet. We are an innovation-first company. And I think our culture is really around what I call almost a straightforward baritocracy. And Ken and Michael drive this throughout the organization. It's very straightforward. It's work hard, work smart, innovate and put the customer first and deliver results. And so I really like the culture. Obviously, I've been here 17 years. Some people say I need to get more creative with my career, but I really – it really gets me excited to make a difference. And it's a positive difference. We're protecting our customers so they can get about their business. So I really like that. And in terms of how I can contribute, up until now I've focused on legal and corp dev. I'm taking over corporate real estate. I'm adding systems, manufacturing and logistics. And so I have a broad set of responsibilities. I also have always worked very closely with the sales teams. I will not be managing the sales teams, but I will continue to work closely. Teamwork is one of our top three culture items here. And we're not really boxed in here in a way. In a way, we really work together. And so we've got great sales leaders, and I look forward to working with them. We've got a huge opportunity to grow. We want to grow and capture that opportunity by putting the customer first. I want to support that. And to the extent I can help the team, I want to do that. To Fatima's question earlier, we're also very disciplined on the cost side. And as Keith said, we have this services model where we have a lot of visibility based on the deferred revenue on the top line. But we also are very disciplined at kind of managing and monitoring the costs on a real-time basis. And, sometimes you can control the costs, more quickly than other things. And so what I've noticed is, we're very good at kind of managing that on a real-time basis, and we'll continue to do that as well.

John Whittle:

Thank you.

Keith Jensen:

And then quickly, Brad, on the other – I mean, yes, obviously, the view of the firewall cycles has some part of it. But I think probably more of the point is the digestion of products and projects. And if you look back at where the peak was of firewall purchasing and you kind of play that out, you should be coming to a logical end of deployment cycles.

Operator:

Thank you. Our next question will come from the line of Keith Bachman with BMO.

Ken Xie:

Yes, a very good question about SASE. Definitely we want to do both, even more than that. So we definitely see the opportunity changing our go-to-market strategy because a few months ago, we were more dependent on the service provider carrier trying to do a SASE. I helped them do a SASE. Now it's more go-to-market, direct ourselves, and at the same time working with our service provider, but also more important, really, internal R&D, internal investment in the infrastructure. Like we mentioned, now we have over 150 pub worldwide, probably can match any other competitor, and same kind of function, the innovation, and also put all the SASE in a single OS, and then a lot of functions that are using ASIC will accelerate, and that also make our SASE solution much better, more advantaged compared to other competitors, and also more easy to deploy, more easy to manage. So we see that's a huge opportunity for SASE. It's not just SASE using the traditional cloud approach, but also on-premise SASE, the private SASE. So we see a lot of opportunity for SASE going forward, both on the technology, which we also work at, our innovation, developing technology, and at the same time, the go-to-market strategy, once we focus, we see huge success behind.

Keith Bachman:

Okay, all right, many thanks. Congratulations, guys.

Ittai Kidron:

Thanks, guys. A couple for me. First, on the comp side, as you move into 2024, can you share a little bit more color on the changes you're making or have made to the sales comp and what kind of incentives have you laid in place in a way that's different than 2023? And then on the competitive front, just given where your position on SecOps and SASE, I think you've talked about kind of more meat enterprise on the SecOps and more SMB is the largest category in SASE. Can you talk specifically on who do you see more as competition in those categories? Because you don't seem to kind of stretch the entire customer profile or regions, frankly. So we'd love to get a little bit more color into who do you see more versus less in those categories. Thank you.

Keith Jensen:

Yes, I'd probably add to that as well just a couple of things on the comp plan conversation. This is the time of year where comp plans go out and I think every company seems to make some changes. I think the real thing that jumps out at me this year is that I think after the 2023 results the quotas are probably a little bit lower on an individual basis than they have been in the past, and we probably put some things to work in the other direction on it. But to Ken's point, we really want to make sure that we're investing in building on the sales team and making the adjustments in the quota for 2024, I think is appropriate. On the SMB and SASE, probably -- the SASE and SecOps conversation. And I think it goes back to some of Gabriela's question before, at this stage, they're really shaping up in terms of having different customer mixes. The SMB portion of SASE was about 55% of the business. And we're not surprised to see us having very, very early success there. We're pleased with the development and the feedback we're getting from third parties about the success of the SASE product. But that, together with our SD-WAN customers is the logical place to see success. On the flip side, SecOps is almost the opposite, but large enterprises providing about 55% of the business. And I think the read through to that is all about consolidation. Where you're really going to have successes and it ties into the mix of repeat customers, i.e., firewall customers are now buying the SecOp product being very, very high. And that's what we would expect both of those business segments.

Ittai Kidron:

Maybe as a follow-up, Keith, how much of the opportunity here in SecOps and SASE is outside of our customer footprint. Is the vast majority of traction here just with your existing installed base? Or it also pulls you outside.

Ittai Kidron:

Thank you.

Adam Tindle:

Okay. Let me see if I can get everybody involved here. So Ken, I wanted to start with SASE and SecOps was obviously a key pivot point on the last call. As you focus on that more internally, could you summarize your competitive advantage technologically in those areas? And John, logistics from a sales perspective, I know it's been kind of kicked around a percent of quota retirement might be related to those areas. What did you land on for logistics? And lastly, for Keith, expectations for sales productivity as a result of that pivot towards SASE and SecOps. Just wondering your early observations on what you've seen because it looks like you do expect total margins down, but I think it's somewhat related to gross margin, not much efficiency drain. So it's just what you're seeing from a sales productivity perspective as you pivot to those areas. Thank you.

John Whittle:

In terms of the quota retirement question, Keith may have additional comments on that, but there's really no change there.

Operator:

That concludes today's question-and-answer session. I'd like to turn the call back to Peter Salkowski for closing remarks.

Operator:

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

Peter Salkowski:

Thank you, Anton [ph] and good afternoon, everyone. This is Peter Salkowski, Senior Vice President of Finance and Investor Relations at Fortinet. I'm pleased to welcome everyone to our call to discuss Fortinet's financial results for the third quarter of 2023. Speakers on today's call are Ken Xie, 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 options 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. [Operator Instructions]. Before we begin, I'd like to remind everyone that today's call, we will be making forward-looking statements and these forward-looking statements are subject to risks and uncertainties which could cause actual results to differ materially from those projected. Please refer to our SEC filings, in particular, the risk factors in our most recent Form 10-K and Form 10-Q for more information. All forward-looking statements reflect our opinions only as of the date of this presentation more 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 cited 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 remarks, both of which are posted on the Investor Relations website. Ken and Keith 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 to growth are on a year-over-year basis unless noted otherwise. I'll now turn the call over to Ken.

Keith Jensen:

Thank you, Ken and good afternoon, everyone. As Ken mentioned, we are confident in our integrated 400S 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 investments in the faster-growing SASE and SecOp 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 lower growth following 2 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 SecOps markets, we believe we can return to delivering mid- to high teens top level growth -- top line growth and while continuing to deliver operating margins of 25% or greater. In other words, a return to balance growth and profitability which has led us to achieve the rule of 40 status in 12 or 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 continue 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 3-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 1 month shorter contract duration and importantly, lackluster appliance demand resulting from elevated product growth in earlier periods. In terms of industry verticals, education and government buildings were strong, while service provider and retail buildings were weak. Small enterprise billings growth was strong, while growth rates with larger enterprises disappointed. Phil's 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 of 16% Prometal revenue grew 16% to $1.33 billion which compares to our 3-year CAGR of 27%. The 3-year CAGR was largely consistent with our 14-year CAGR illustrated on Slide 18. Product revenue of $466 million, representing a 3-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 can refer to. Service revenues of $869 million grew 28%, representing a 3-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 3-year CAGR to illustrate how consistent they are. With the same CAGR starting from our 2009 IPO which were illustrated on Slide 18, each of the 3-year CAGRs, billings, product revenue, service revenue and total revenue are within 5 points of the 14-year CAGR 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 6-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 on the high end of our guidance range, reflecting our efforts to control spending. Looking to the statement of cash flow, summers on Slides 15 through 17. Free cash flow increased 22% to $481 million, representing a free cash flow margin of 36% or 9 points above consensus. Operating cash flow increased $68 million to 41% of revenue. Capital expenditures of $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 7-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 continue their consolidation journey with us, supplementing their earlier SecOps, cloud and network security purchases. And in a 6-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 Gartner's release of the inaugural single vendor SASE Magic Quadrant, where we were named a challenger. By 2025, 1/3 of new SASE deployments are expected to be single vendor. I should also note Fortinet is recognized in 9 Gardner Magic Quadrants as shown on Slide 3. 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 SASE features into 40s [ph] and continuing to expand our SecOp 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, our investments include actively promoting our challenger position in Gartner a 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 competitive advantages and the key components of SASE, SecOps and network security as summarized on Slide 10. Certifying 5,500 foot net sales professional of SecOps solutions after all ready 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 and is focused on differentiating Fortinet's is 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 Gartner, 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 9, Pertinent brings consolidation across SecOps, SASE and network security the 3 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. Attending 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 us into consideration. As a reminder, our fourth quarter and full year outlook which are summarized on Slides 20 and 21, is subject to the 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 billion to $1.700 billion which at the midpoint represents a decline of 5%. Revenue in the range of $1.380 billion to $1.440 billion which at the midpoint represents growth of 10%. Non-GAAP gross margin of 75.5% to 76.5%; non-GAAP operating margin of 27.5% to 28.5%. Non-GAAP earnings per share of $0.42 to $0.44 which assumes a share count of between 780 million to 790 million; capital expenditures of $40 million to $60 million; a non-GAAP tax rate of 17%. And cash taxes, as I mentioned, are $345 million [ph]. For the full year, we expect billings in the range of $6.095 billion to $6.235 billion which at the midpoint represents growth of 10%. The Revenue in the range of $5.270 billion to $5.330 billion which is the midpoint represents growth of 20%. Service revenue range of $3.355 billion to $3.375 billion which at the midpoint represents a growth of 28%. The service revenue guidance implies product revenue growth of 9%. Non-GAAP gross margin of 76% to 77% and 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 count of between 790 million and 800 million. Capital expenditures of $220 million 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 gross 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 and from backlog draws in the first half of 2023 and the benefit of our SASE and SecOps focus. We expect contract term to remain below our high water marks of 2022. We Consistent with prior years, we expect that the timing of service revenue growth trends will lag product growth trends. Longer term, we 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.

Operator:

[Operator Instructions] Our first question comes from Hamza Fodderwala from Morgan Stanley.

Ken Xie:

I think it's a little bit different business model. SASE is more the service OpEx compared to the networking dip CapEx, during the slow economy environment, customers definitely move towards service-based OpEx. So it will be also since some of service providers kind of a little bit slower to adopt some of the SASE that -- we have been involved in SASE a long time. And some of the service provider kind of slower than we expected. So that's where we kind of changed some of the strategy more aggressively going ourselves at the same time, still working closely with the partner.

Brian Essex:

I guess maybe, Keith, for you, as we look at the trajectory of product declines this quarter in 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 a 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 billings or both in the second half, understanding you're going to have easier comps as well?

Ken Xie:

Long term, we still don't believe the convergence of network into network security will be happening which also valid by like [indiscernible], by 2030 the network security secure networking will be larger than the traditional networking, especially in the compass environment, in the 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 are keeping gaining market share in both network and also in the SASE market.

Fatima Boolani:

Keith, in your prepared commentary, you specifically called out the service provider and retail vertical perhaps exceptionally weak in their buying. 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 how and why the buying intentions have sort of rolled over in these 2 areas specifically?

Operator:

Our next question comes from Tal Liani from BofA.

Ken Xie:

Yes, it's Ken. I think for SD-WAN, they do need a place to be in place to deliver all these SD-WAN functions there. We really offer SD-WAN as part of the [indiscernible] Function for free and we started launching the SD-WAN service last quarter. So it's still in the ramp-up stage. We do believe one to all the service, we're keeping accelerating like the SASE market will be growing faster than the secure networking market. I think that's where for certain like -- I think there's a chunk on the presentation shows some of the product and service which is in 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 just started the new cycle of the new ISP5 [ph]; we have a one or two product as starting launching which gave us like a 5 to 10x better performance and more function at the same cost. Which also combined with the supply chain kind of elevated shipment of building in the last 2, 3 years. Because it's combined together, I feel have affected our price sales in the last few months. But I do believe this since we'll go back to normal probably in second half of next year. After the new product being fully launched after the supply digestion but inventory directions kind of go through because we do see the long-term convergence story is still holding well. We have a big position with better integrated OS with salvation. And our plan as a part of the whole solution. It's a hybrid solution, both our part cloud, especially we call the universal SASE. So that's -- 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.

Operator:

Our next question comes from Saket Kalia from Barclays.

Ken Xie:

Yes. The first answer is, yes, now we are ahead at 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 of 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 allows the customer a more like our solution instead of sometimes you have to deal with traffic, whether enough is office have to fold the part because our solution you can process some traffic locally on campus within their appliance.

Operator:

[Operator Instructions] Our next question comes from Brad Zelnick from Deutsche Bank.

Ken Xie:

We do believe in this fast-growing SASE SecOps market, the sales training, sales restructuring. At the same time, more efficient marketing is very, very important. And also, we are continue working closely with our channel partner with our distribution network to reaching more broad customer base. So we're also thinking the large cross-sell opportunity is huge and especially go through our partner network there. So I don't feel the investment we've made in the past will be any issue or kind of any slow us down. We do believe we are actually helping us to expand in this more service basis SASE market and also more consolidation secure approach.

Brad Zelnick:

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 help deliver the infrastructure. How should we think about the CapEx required to do this in a competitive way over the longer term?

Keith Jensen:

To Ken's point, look, we were -- last quarter, we were talking about 20 PoPs because we're building them ourselves, right? 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, to 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 they are 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 SecOps. So I think this is not something that we're going to surprise people with in terms of our CapEx spending.

Adam Tindle:

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 is already very healthy. You've got a lot of capacity. Right now, the market is 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&A. And conversely, if we look at the after-hours action here, the ROI on share repurchase is looking potentially very strong 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?

Ken Xie:

We're definitely keeping looking. I think right now, the multiple probably more reasonable than the last 1 to 2 years. And also, we do realize the marketing also changing pretty quick. We'll continue to do the internal innovation. We feel we are the strongest on the internal innovation engineering among all the space, player. But on the same time, we also were open to looking for some other companies which we can work together, join together.

Keith Jensen:

Yes, 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 you're getting as we look into 2024 in terms of where the pressure may come from.

Keith Jensen:

Quantify, no.

Operator:

Next question comes from Adam Borg from Stifel.

Ken Xie:

Yes. We -- if you look in the last 2, 3 years, we're growing a lot of business also hired a lot of salespeople -- and the last 2, 3 years, we probably doubled the business. And at the same time, during the supply chain, you should somehow certain sales feel it too easy to get deal because as always a shortage of certain product there. So that's where we feel we need to enhance the training enablement and -- at the same time, I also need to be more disciplined about the performance. So that's -- at the same time, we also -- when we're shifting this to more like a service-based SASE kind of consolidation cross-sell multi-cell secure part sales also need to keep in learning. At the same time, the market 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 the sales and marketing going forward.

Ken Xie:

Yes, it's very good that give us a very quick start to match any other competitor on the location, number of [indiscernible] number up and they also have a broad coverage, so it's a good partnership. At the same time, we continue to working with some other partners. We also will continue to build ourselves. And the long term, we feel we have more advantage than some of our competitors because we always have a strategy invest in some long-term or long-term investment strategy, including some real estate, some other parts which give us a much better long-term return.

Unidentified Analyst:

All right. Ken, Keith, Peter. My question is about being, I guess, kind of qualitative guidance you guys gave for 2024 billings. If I remember correctly, in last quarter, it was expect kind of high teens busing growth exiting fiscal '24. Was the commentary this quarter expect double-digit growth exiting 2024?

Unidentified Analyst:

I'm just trying to -- so last quarter, you guys gave some kind of like a 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?

Operator:

Our next question comes from Joseph Gallo from Jefferies.

Keith Jensen:

Yes. And I wasn't quite sure if the question was about the Q4 guide or the 2024 commentary about numbers.

Keith Jensen:

Yes. I would say that, while we just deal with 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 5 years here for context. And they're obviously lower than what I saw in the -- what I used for the first half of the year. And 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 2 quarters, I don't think that should put much stock in that. So I'm content to just assume a much lower close rate than I have more recently. 2024 are not really giving guidance. I think that, again, we're talking about buildings 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. 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.

Operator:

Our next question comes from Gray Powell from BTIG.

Ken Xie:

Yes. Actually, we do give the market growth for these 3 segments going forward. And we also believe we're growing faster than the market growth, gaining share in all the 3 segments. Related to the firewall FortiGate versus some other AP switch. We do see more headwind in AP switch for the AP switch because a lot of supply chain issues kind of pretty much over. And so it's -- so that's probably more headwind compared to the firewall secure networking for side.

Eric Heath:

Great. 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 is kind of doing an apples-to-apples switch over from kind of the firewall customer over to SASE. And then secondarily, with the shift away from farewell, that probably means more of a shift to annualized billings. So curious how you're thinking about duration and that impact to free cash flow going forward?

Ken Xie:

Yes, we also will be keeping salaried training for internal sales force also to our partner for this new SASE SecOp operation which is a little bit different than the traditional secure networking side. So that we also feel the -- with a huge installation base. We have SD-WAN firewall which we're leading. We're number one pretty much in all this area, we feel the huge potential to upsell cross-sell the SASE and secure up once the sales force unevens the partner for the train.

Peter Salkowski:

Thank you, Anton. I'd like to thank everyone for joining the call today. Fortinet will be attending investor conferences hosted by Barclays, Stifel and Wells Fargo during the fourth quarter. Partially chat webcast link will be posted on the Events and Presentations section of the Fortinet Investor Relations website. If you have any follow-up questions, please feel free to contact me. Have a great day today. Thank you, Bo.

Peter Salkowski :

Thank you, Trace. Good afternoon everyone. This is Peter Salkowski, Senior Vice President of Finance and Investor Relations at Fortinet. I am pleased to welcome everyone to our call to discuss Fortinet's financial results for the second quarter of 2023. Speakers on today's call are, Ken Xie, Fortinet's Founder Chairman and CEO and Keith Jensen, our Chief Financial Officer. The live call that will be available for replay the webcast on the Investor Relations website. Ken will begin our call today providing a high level perspective of our business. Keith will then review our financial and operating results for the second quarter of 2023 before providing guidance for the third quarter of 2023 and updating the full year. Will then open the call for questions. 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. Before we begin, I'd like to remind everyone that on today's call, we will making forward-looking statement. And these forward looking statements are subject to risks that could cause actual results to differ materially from those projected Please refer to our SEC filings in particular the risk factors in our most recent Form 10-K and Form 10-Q for more information. All forward-looking statement reflect the opinions only as of the date of this presentation and we undertake no obligation and specifically disclaim any obligation to update forward-looking statement. Also, our references to financial metrics that we make today on today's call are non-GAAP unless stated otherwise. Our GAAP results and GAAP to non-GAAP reconciliations are located in the earnings press release and in the presentation that accompanies today's remarks, both of which are posted on the Investor Relations website. Ken and Keith's prepared remarks for today's earnings call, will be posted on the quarterly earnings section of our Investor Relations website immediately following today's call. Lastly, all references to growth there on a year-over-year basis unless noted otherwise. I will now turn the call over, Ken.

Keith Jensen :

Thank you, Ken. And good afternoon everyone. Let's start with the key highlights from the second quarter. Billings growth was 18% as well as product revenue growth, service revenue growth held firm at 30%, resulting in total revenue growth of 26%, OT and SD-WAN revenue continue to perform well as revenue from these products were up 60% and 40%, respectively. In a sign of our strength in the small and midsized customer segments, we added a record 6,500 new logos. Operating margins of 26.9% exceeded the high end of the guidance range by 140 basis points. Free cash flow was strong at $438 million, representing a margin of 34%, benefiting from the deferral of certain cash tax payments to the fourth quarter. Looking at buildings in more detail buildings of $1.54 billion were led by non-FortiGate billings over 30% growth, representing 34% of total billings. Non-FortiGate billings growth was driven by networking FortiGate VM, NAC [ph] and cloud. And as Ken mentioned, non-FortiGate is nearing a $2 billion annual revenue run-rate. In terms of industry verticals, government and manufacturing topped the list as a percentage of total billings, with manufacturing up almost 50%, government and construction were up over 30%, while service provider and retail were up 1% and down 5% respectively. Retail was impacted by a very difficult compare, as the industry vertical nearly doubled in the year earlier period. Billings growth vary by GIOS with international emerging leading, followed by Europe and the LatAm. APAC and to a lesser extent U.S. enterprise were challenged by difficult prior year comparisons. Deals over $1 million increased from 122 deals to 134 deals. Turning to revenue and margins. Total revenue grew 26% to $1.29 billion, driven by non-FortiGate growth of over 45% and service revenue growth of 30%. This was the second consecutive quarter of greater than 30% service revenue growth. Security subscriptions represent over 55% of all service revenue and continue to streak a strong increasing sequential quarterly growth dating back to Q1 of '22 of 23% to Q2 of '23 at 34%. Product revenue of $473 million increased 18%. Product lead times and backlogs are expected to approach normal levels in the third quarter. Total gross margin of 77.9% was up 140 basis points driven by 160 basis point increase in product gross margin to 63.5%. Product gross margin has benefited from earlier pricing actions and easing cost pressures and were partially offset by certain inventory charges. Service revenues were 63% of total revenues and delivered gross margin of 86.2%. Higher service revenue, offset higher labor costs and increased cloud delivery costs, as we continue to expand our cloud SASE delivery models. We see our single vendor SASE solution opening a large new market and one where our sizable SD-WAN install base can be leveraged as a significant market access point. We plan to accelerate our point of presence or POP deployment, with a dual strategy Ken mentioned investing in our own POPs, as well as working with third party providers to accelerate our deployment. Operating income of $348 million, grew 36% outpacing revenue grew by more than 10 points as operating discipline resulted in significant operating leverage. Operating margins of 26.9% exceeded the high-end of the guidance range and was up 210 basis points due to the strong gross margin performance and operational efficiencies. Earnings per share increased 58% to $0.38 per share, and also exceeded the high-end of the guidance. Looking into the statement of cash flow summaries on Slide 7 and 8, free cash flow increased 55% to $438 million. The adjusted free cash flow, which excludes real estate investments was $498 million, representing it 38.5% adjusted free cash flow margin. Free cash flow benefited from the deferral of approximately $190 million in cash tax payments. As mentioned last quarter, these tax payments together with other deferred 2023 tax payments are due to be paid in the fourth quarter. Capital expenditures were $77 million, including $59 million of real estate investments. Cash taxes on the quarter were $38 million. The board recently increased the company's share repurchase authorization by 500 million. And the total available share buyback authorization is now approximately $2 billion. Now I'd like to share a few significant wins from the quarter that exemplifies the strength of our broad and integrated platform. First, a global pharmaceutical leader signed an eight-figure deal without Fortinet Cybersecurity Fabric, investing in our OT aware secure networking architecture, as well as our AI ops and threat intelligence solution. Recognizing the market shift to a platform-based approach to security, this company selected Fortinet to secure its highly regulated and sensitive medical data that continues to drive global operational and financial efficiencies through our broad integrated and automated platform approach to cybersecurity. In another deal, one of the largest U.S. school districts which had recently refreshed its datacenter firewalls to FortiGate was seeking to improve its network security posture with a NAC solution that offers better visibility to the devices connected to the network. Fortinet competed against multiple peers, and was able to win did a FortiNAC's ease of implementation, centralized management capability and superior risk remediation, as well as the tight integration to the district's existing Fortinet security fabric. This high seven-figure deal was the largest NAC deal in Fortinet's history. Finally, in the seven-figure displacement in our largest FortiSASE deal ever, a large bank on its digital transformation journey, who was searching for a single vendor SASE solution for its hybrid workforce. This selected our FortiSASE solution for over 5,000 users, as it integrates SD-WAN and SASE into a holistic solution and delivers comprehensive security, both from the cloud and on prem, while ensuring consistent security policies for all users regardless of their location, and wherever applications are being accessed. These transactions illustrate how Fortinet's platform strategy, integrated operating systems and proprietary ASIC technology continues to resonate with customers. Given the heightened interest in AI technology, we could not do this call without discussing Fortinet's investment and innovations in AI. Fortinet has been at the forefront of AI and machine learning innovation for many years, leveraging deep learning and artificial neural networks to power our products and security services, enabling a faster, stronger and more accurate defense for our customers. One of our first AI-powered use cases was the introduction of the virtual FortiGuard Threat Analyst. FortiGuard addresses threats in real time with machine learning, coordinated protection and is extensively used in malware detection and threat hunting. Every time the threat is identified, FortiGuard generates threat intelligence that automatically updates defense signatures across the fabric. In cloud environments where scale and speed are critical, AI and machine learning can help security teams keep pace with threats on multiple fronts. All of this happens seamlessly and behind the scenes. Today, our platform Guest and Analyzer on average more than 100 billion events every day, to deliver over 1 billion security updates daily across the Fortinet security fabric and ecosystem. While many of our competitors OEM their security from different security vendors. Our AI-driven FortiGuard threat intelligence has been built in house, which allows us to use AI across different sources. Adversaries increasingly are using AI in their playbooks to drive cyberattacks, which only increase the rapidly evolving cybersecurity threat landscape. We continue to invest in AI and machine learning technologies across our products, including generative AI, natural language models, and other implementations to enhance, simplify and automate security for our customers. Before moving to guidance, I'd like to offer some observations about the second quarter and about the industry. Regarding the second quarter, we believe macro and certainly impacted our billing performance to average contract duration, and in the second half of June, and the elevated level of enterprise deals pushing the future quarters. We saw shorter contract duration, with the average term decreasing by 1.5 months to 28 months, creating a 4 to 5 point billings headwind year-over-year. Normalizing billings growth with a change in contract duration, yields billings growth in the low-20% range. Having some level of enterprise deals pushed to future quarters, it's not unusual. In Q2 '23 however, an unusually large volume of deals that we expected to close in June, instead push to future periods. From a market perspective, CIOs continue to prioritize and invest in securing their organizations in the face of rising cybersecurity threats. We see new regulatory requirements, such as the recently announced -- those recently announced by the SEC and the EU Cyber Resilience Act announced earlier this year. They will continue to provide market tailwinds as organizations further increase their cybersecurity investments to comply with new stringent cyber regulations. The cybersecurity industry remains highly relevant as CIOs prioritize cyber spending within the overall IT budgets. As such, the longer term demand drivers for Fortinet net remained very solid. That said, we do see a return to more normal seasonality for Fortinet in the back half of the year. That's tailwind such as the supply chain driven growth subsides. And we cycled prior period price increases. Moving on to guidance. As a reminder, our third quarter full year outlook, which are summarized on Slides 11, and 12, are subject to the disclaimers regarding forward-looking information that Peter provided at the beginning of the call. For the third quarter we expect billings in the range of $1,560 million to $1,620 million which at the midpoint represents growth at 13% and is consistent with our quarter-over-quarter seasonality prior to the pandemic. Revenue in the range of $1,315 million to $1,375 million which at the midpoint represents growth of 17%. Non-GAAP gross margin of 75.5% or 76.5%. Non-GAAP operating margin of 24.5% to 25.5%. Non-GAAP earnings per share of $0.35 to $0.37. This assumes a share count of between $795 million and $805 million. Capital expenditures of $100 million to $130 million non-GAAP tax rate of 17% cash taxes of $25 million. And as previously mentioned, backlog is expected to approach normal levels in Q3. For the full year, we expect billings in the range of $6,490 million to $6,590 million, which at the midpoint represents growth of 17% and apply slightly below normal seasonality in Q4. Revenue in the range of $5,350 million to $5,450 million, which at the midpoint represents growth of 22.3%. Service revenue in the range of $3,350 million to $3,410 million with the midpoint represents growth at 28.2%. The service revenues guidance implies product revenue growth at 13.5%. Non-GAAP gross margin of 75.25% to 76.25%. Non-GAAP operating margin of 25.25% to 26.25%. Non-GAAP earnings per share of $1.49 to $1.53, which assumes a share count of between $795 million and $805 million. Capital expenditures of $335 million to $385 million due to our continued cloud data center and facilities investments. Non-GAAP tax rate of 17%, cash taxes of $460 million with approximately $380 million in the fourth quarter. We continue to execute our long-term strategy and remain confident in the strategy and our solutions. While it's a little early to be providing guidance for next year, we would expect our near term performance or represents a short term trough. Given our confidence in our solutions, our offerings -- and taking into account that growth comparisons will ease as we move through 2024 that this early stage we would expect billings growth to approach high-teens by the fourth quarter of 2024. And with that, I'll now hand the call back over to Peter to begin the Q&A session.

Operator:

Thank you. [Operator Instructions] Our first question is from [Indiscernible]. Your line is open.

Ken Xie :

Sure. I think for the carrier service provider, we do see they're probably a little bit behind on offer some surveys because the carrier service provider, if you look back 10-15 years ago, is our biggest market. It's like about 30% market share comes from the carrier service provider. But nowadays, security need additional service like some SASE, all these function -- function in the SASE, which service provider kind of behind, so we're still working with them and closely try to help them accelerate the service. At the same time, we're also starting to invest a little bit more self, which also, like together with the new service we announced today, the two new SD-WAN service, we feel invest in certain infrastructure that will help in drive a lot of new service going forward in the security space, and also in helping service providers to kind of accelerate some of their security service beyond the traditional security service.

Ken Xie :

We're also interested in some cloud provider also started getting in the security space, which also kind of confused some of the enterprise customer. So that's also sometimes they take a little more time to evaluate our different solutions. So we do believe this is a hybrid approach on-premise in the cloud that will be best for the customer, even the cloud probably much more expensive or cost an average about 3x to 5x more expensive compared to on-premise, but it's -- combined altogether probably will be the best solution for customers.

Keith Jensen :

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

Operator:

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

Keith Jensen :

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

Keith Jensen :

Yeah. And as I kind of take that commentary and pull it forward a little bit and say, Q3 and Q4, and I suspect I'll get a fair amount of chance -- opportunities to talk about the guidance setting process for Q3 and Q4. I guess I would start off by saying we've certainly seen over the last two or three years in various environments we've been in. You got to be pretty nimble in terms of your assumptions and what you're looking for. And with that in mind, I think I called out in the comments, you see the level of deals that pushed in the second part of June. It was a new development. We always have linearity of the deals closed to see the deals push. And I think 1 comment I would offer is that as you look -- as I look to the Q3 guidance setting and the roll-up, the assumptions for Q3 were to close rates and terms and things of that nature and push. I would say, look a lot more like the assumptions that we saw in actual results for Q2 than maybe what we saw with some higher rates, better rates earlier on. So I think there's some caution built into that, if you will. I think also if you kind of look at the results, where the guidance ends up, you can look at top line growth in Q3 versus Q2 that I think is in the low-single digit growth sequentially. And that's pretty much in the range of where we've seen Q2 to Q3 historically, and we would expect that again. And then maybe just a little more caution in the fourth quarter where -- and again, I made a comment earlier that the seasonality assumption that falls out of the guidance for the full year and is applied to the fourth quarter actually suggests a lower level of growth in the fourth quarter than we've seen in other periods. Offering a certain degree of caution, number one, but also acknowledging that Q4 last year was a very strong quarter and pretty tough compare.

Gabriela Borges :

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

Ken Xie :

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

Ken Xie :

Thank you.

Tal Liani :

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

Ken Xie :

I don't know why Palo Alto is like at Friday afternoon, which is probably -- I'm not one want to answer the question. But on the industry, we do see some company, especially large companies, to be more tight on the budget, and also kind of take a little bit long time to closing. It's not just that this quarter, basically pretty much starting early this year, there is some sign of that one. How long will last? It's tough to say, but it's -- nearly the security is basically an underspend, then they probably will be starting to go back up after probably a few quarters. On the other side, if you see when the big environment starting kind of tough or tight, they tend to be more hand on the current product, current solution and then buy more service, which we also try to help new customers net whatever they have on hand to offer more service, like the SD-WAN service we announced today. So, let's see, the service revenue starting kind of doing well, leverage or kind of the last few years. The product revenue growth, which we already be the #1 in the product revenue in the whole network security space, which is over 28% market share, and also unit shipment is over 52% market share. So I think we'll continue to keep leading in the space and with new technology solutions, like the FortiGate 90G we announced today. But it's -- for us, more focused on long term. So we do believe the long-term convergence of network to network security, we feel we have the best technology product to meet that challenge. And at the same time, the short-term environment, we tend to be also see as an opportunity to keep gaining market share.

Ken Xie :

Yeah, the backlogs are already back to normal now, back to that before the supply chain issue. And you can see last year towards the middle to the end, we already see the FortiGate. We already solved the issue. The majority of most of that will come from some network-related products. That's also been eased up in the first half of this year. Backlog kind of back to normal before the supply chain addition. And they do have certain cancellation. Ideally the cancellation, probably double digit?

Tal Liani :

Great. Thank you.

Brad Zelnick :

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

Keith Jensen :

Yeah. Brad, it was a great question and kind of follow on with Ken there. When I look at the win rates for, say, our top 3 competitors, right, they are in the firewall market, I'm not really seeing a change in the win rates, loss rates. They were quite consistent, maybe improved in one of the three cases that -- of the names that we know. I think that what -- what we don't know is how much is specific to us was that we had deals teed up for the last couple of weeks of the quarter that we're on a path to close and they did not close. So how -- the question comes is that something about the macro and the enterprises that are pushing out spending a little bit? Or is it some area that we need to reprove on in terms of how we go at our own internal inspection and forecasting and look at the detailed deals, right? We'll know more about that as time plays out.

Brad Zelnick :

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

Brad Zelnick :

Thank you, very helpful.

Eunji Song :

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

Eunji Song :

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

Peter Salkowski :

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

Saket Kalia :

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

Saket Kalia :

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

Saket Kalia :

No, no problem. We can take it offline.

Saket Kalia :

Very helpful.

Saket Kalia :

Thanks, guys. Thank you.

Operator:

Thank you. Our next question comes from Shaul Eyal with TD Cowen. Your line is open.

Keith Jensen :

I'm not quite sure -- are you looking for the distribution of salespeople hitting quota? Or -- I'm not sure I follow the question you're try to get at, Shaul.

Keith Jensen :

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

Keith Jensen :

Sorry, resellers I'm sorry. I don't know. You're answering the right question. [Indiscernible] distributors, yeah.

Keith Jensen :

Yeah. I don't think that -- of our business, if you will, shifted at all significantly. We look at our top three and our top six distributors, we're fairly concentrated in that regard. That mix doesn't really change all that much, maybe point or 2 in the quarter. That wasn't something that we saw that's just out there at us.

Keith Jensen :

Yes.

Operator:

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

Keith Jensen :

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

Joseph Gallo :

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

Keith Jensen :

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

Joseph Gallo :

Thank you.

Andrew Nowinski :

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

Andrew Nowinski :

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

Andrew Nowinski :

Thank you.

Peter Salkowski :

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

Peter Salkowski:

Thank you, Chris. Good afternoon, everyone. This is Peter Salkowski, Senior Vice President of Finance and Investor Relations at Fortinet. I'm pleased to welcome everyone to our call to discuss Fortinet's financial results for the first quarter of 2023. Speakers on today's call are Ken Xie, Fortinet's Founder, Chairman and CEO; and Keith Jensen, our Chief Financial Officer. This is a live call that will be available for replay via webcast on our Investor Relations website. Ken will begin the call today by providing a high-level perspective on our business. Keith will then review our financial and operating results for the first quarter of 2023 before providing guidance for the second quarter of 2023 and updating the full-year. We'll then open the call for questions. During the Q&A session, we do ask that you please limit yourself to one question and one followup question to allow others to participate. Before we begin, I'd like to remind everyone that on today's call, we will be making forward-looking statements, and these forward-looking statements are subject to risks and uncertainties, which could cause actual results to differ materially from those projected. Please refer to our SEC filings, in particular, the risk factors in our most recent Form 10-K and Form 10-Q for more information. All forward-looking statements reflect our opinions only as of the date of this presentation, and we undertake no obligation and specifically disclaim any obligation to update forward-looking statements. Also, all references to financial metrics that we make today are non-GAAP unless stated otherwise. Our GAAP results and GAAP to non-GAAP reconciliations are located in the earnings press release and in the presentation that accompany today's remarks, both of which are posted on the Investor Relations website. Ken and Keith's prepared remarks for today's earnings call will be posted on the quarterly earnings section of our Investor Relations website immediately following today's call. Lastly, all references to growth are on a year-over-year basis unless noted otherwise. I'll now turn the call over to Ken.

Keith Jensen:

Thank you, Ken, and good afternoon everyone. Let’s start with the key highlights from our strong first quarter performance. Our strong first quarter results reflect a continued demand for our broad portfolio of cybersecurity and networking solutions and the demand for consolidation and convergence that is delivered by our integrated, single platform strategy. Total revenue growth of 32% was led by strong product revenue growth and service revenue growth accelerating to over 30%. Billings increased 30%, our eighth consecutive quarter of at least 30% billings growth. Secure SD-WAN and OT bookings once again accounted for over 25% of total bookings. Our strong top-line results reflect continued customer demand across both Core and Enhanced Platform Technologies, and highlights the diversification of our business model by solutions, geographies, customer segments, and industry verticals. We continued to deliver balanced growth and profitability with better than industry average top-line growth and strong profitability despite the continued economic uncertainty. The first quarter operating margin of 26.5% represents the highest first quarter operating margin in our 14-year history as a publicly traded company. Free cash flow was $647 million, representing a margin of 51%, up 23 percentage points. Both the quarterly free cash flow and free cash flow margin are Fortinet post-IPO records. Last month we hosted nearly 3,000 customers and partners at our very successful Accelerate Conference and I’d like to recap three key themes

Operator:

Thank you. [Operator Instructions] Our first question comes from Brian Essex from JP Morgan. Your line is open.

FortiGuard:

By that I mean, the customer did register a little bit faster in the first quarter, but that lag or that registration policy change that we implemented in the first quarter, I would specifically call out is not really having an impact in the first quarter, nor did we really expect one. So kind of in order, I think it was selling into the install base price increases and then some light improvements in the registration behavior.

Ken Xie:

Yes, also with the new FortiOS 7.4 that started launching, we started to have a more function. We can also enable much more new service going forward for both the current customer installation base and also for new customers.

Keith Jensen:

Yes, I think in the guidance particularly as we look at the full year, it's kind of difficult to figure out exactly which quarter some of that backlog is going to end up in or be canceled. But for the full year, I think we talked about low single digit growth that would be coming from the backlog. I do think that the risk to cancellations increases as the year progresses, and by that I mean if a customer has only been in backlog for a week or a month or something like that, there seems somewhat less probability that they're going to cancel. But the longer it takes to deliver on that backlog, I think the cancellation risk continues to increase.

Brian Essex:

Got it. Very helpful. Thank you both very much.

Gabriela Borges:

Good afternoon. Thank you. I have one for Ken or for Keith, it's a followup question on forecasting, which is, we've heard so much noise in the industry around supply chain and COVID catalyst product cycles. How do you all think about true demand and potentially planner and the risk of demand going faster than expected, given you've had a very strong couple of years? Thank you.

Gabriela Borges:

Yes, that, that makes sense. Thank you. And Ken the followup is for you, which is, as you start to execute more on the convergence of selling into the networking budget or the convergence of networking plus security, when you look at the classic networking competitors, how do you think about the barrier or the limitation for classic networking vendors to get more into security and become more competitive in the convergence over time?

Gabriela Borges:

Thanks for the detail. Congrats on the quarter.

Operator:

Thank you. One moment for the next question. The next question comes from the line of Fatima Boolani of Citi. Your line is open.

Ken Xie:

Yes. First of all, SASE kind of a vision is little bit different than some of competitors. We do believe need to be universal, need to be more broadly deployed and also more leveraged, a lot of service provider infrastructure. It's kind of a hybrid environment inside of a cloud only SASE solution. And we do keep on expanding some of our path because there's a, definitely, there's some user like whether depend on working from home as a mother or SASE to secure some of their traffic here. But on other side, there's a huge base of customer need to using SASE, our kind of service model, leverage both service provider out their current infrastructure and even onsite appliance. And so that's where in certain point we also see our FortiSwitch and FortiAP are kind of have a agent to helping for the traffic for the Forti [indiscernible] to process all this SASE traffic there. So that's where, that's the reason we kind of put SASE in a single OS, both on the networking side of function like [indiscernible] brand strategy and other plus the security like a CASB DLP, [indiscernible] service, all these things. So that's where we have a more integrated, more broadly distributed and leverage whatever the hyper infrastructure size solution there. That's also the reason we continue to build some other PoP. It's a little bit different than some other leverage certain cloud provider because we do see the cloud provider potentially also can be the service provider to offer SASE and also from the [indiscernible] I point of view even have a little bit more investment from the beginning to build on PoP our self, but long-term will be more profit model, so we have a better margin so that, so we will take some time to make sure we build a healthy ecosystem, both with our partner and also with the investment for long-term benefit.

Keith Jensen:

Yes. I would say one just kind of as a general thought, I think that raising it to some extent I think probably gives you a little bit of a message that we feel good about our strategy and the execution that level that we can bring to the market. But more specifically and more tactically as we look through the second half of the year, there's probably a little more rigor and effort, if you will, in trying to look at what we see coming in the second half of the year. And I would give you that probably the two headlines that we're looking at. One is we're still very, very pleased with the pipeline. The pipeline continues to be well above anything that we're talking about, growth rates for the company for the full year. But I think the nuance that and maybe it's not even a nuance really that's coming into play now it is more about close rates. It's not just as simple as taking your pipeline and assuming you're going to have close rates that were at the same level they were in prior periods, and that's when we use the term close rates, not a suggestion that deals are getting lost, but this continual cycle that we seem to be in, where some of the larger enterprise deals in particular are taking longer, they're pushing out a lot of pushes. It's not that there's been an increase in losses, but the continual push. And so with that in mind, I think a fair amount of attention of looking at the full year guidance on what we really think our close rates may be for the second half of this year.

Operator:

Thank you. One moment for the next question. This question comes from the line of Saket Kalia of Barclays. Your line is open.

Ken Xie:

Yes we definitely see some healthy growth of enterprise agreement. And also we're working closely with our channel partner with our service provider also leverage their connection, their resource to build a healthy ecosystem to grow together. But I also see from enterprise level, they also see the benefit of consolidation, definitely. And also not just consolidate some of security product, but also on the expanded infrastructure go beyond the traditional network security. So that's also, we see pretty healthy growth like a cure, and we do see that we could enhanced technology side also has pretty healthy growth. Yes, the sales force also, you can see the number of 1 million deal both on the number and also on the dollar wise has a pretty healthy growth continue to accelerate and grow beyond the total building growths. So that's, that's a pretty healthy trend we see going forward to helping customer consolidate.

Saket Kalia:

Got it. That's super helpful. Keith, maybe for my followup for you, great to see that 30% growth and acceleration in services revenue. Maybe the question is, how do you think about what portion of your existing subscription base hasn't seen that cumulative impact of the price increases you've done yet. Right? Like clearly the price increases on product have been fully baked, but how much of the base, or maybe how long will it take for the subscription base to fully realize that pricing as well?

Saket Kalia:

Very helpful. Thanks guys.

Shaul Eyal:

Thank you. Good afternoon. Congrats on results and guidance in tough macro. Keith maybe starting with you, can you comment, can you provide us with some color about the financial vertical performance this quarter?

Shaul Eyal:

Got it, got it. From a product mix perspective, so the entry level performed the best versus the high end. Is that just a mix or a macro reflection? And, and also did you have any eight digit wins this quarter?

Shaul Eyal:

Okay.

Ken Xie:

Yes. Also our SMB [ph] had a pretty healthy growth. Like I said, the SMB is a more greenfield for the network security. We do see more and more SMB need and network security to protect their business, especially comes from some other ransomware attack. On enterprise because it's a kind of more replacement and also a lot of enterprise kind of maybe the bigger [indiscernible] how we're more dependent on the service. So that impacts some of the high end. And also the other benefit for some of the low and middle range is really most I would say most IC one and some of the OT deployment are maybe towards the low end, middle range.

Ken Xie:

Thank you.

Rob Owens:

Thank you very much and good afternoon. Thanks for taking my question. I want to start around OpEx or the correlated operating margin and a very strong first quarter here, I think you mentioned it was the strongest Q1 that you've had since you're public. If I go back through results since you've been public, Q1 has never really been the high watermark from an operating margin standpoint. So walk me through your thought process as the rest of this year plays out was there some aberration in Q1 that really helped drive that or just a lot of conservatism as we look ahead?

Rob Owens:

Great. And then as a followup, I did want to touch on the OT business and the strength you're seeing there? Can you talk a little bit from a go-to-market standpoint and some of the channel programs, because it does seem like there's some new large channel partners out there that are very excited about the opportunities? Thanks.

Operator:

Thank you very much. One moment for our next question. The next question comes from Adam Borg of Stifel. Your line is open.

Keith Jensen:

Yes. Well, first of all, I want to revel in the $600 million of free cash flow, which I've been doing it for some of more quarters, but I'm trying to let people know that a lot of the things fell our way in the quarter. There's always, the conversation in part of the sales cycle, if you will, the customers got a one-year, three-year, five-year deal. And certainly in a rising -- in an environment where interest rates have gone up, I think there's a lot more, many more conversations that exist, around payment terms and things like that. I do believe that, just as we just talked about in the second quarter of 2020 when COVID hit, we have a very strong balance sheet. We obviously have very strong margins, and it's appropriate for us to look at that, to that as opportunities to leverage our balance sheet and sometimes that may be in the form of extended payment terms or what have you, and our income statement in the form of, how we want to go about discounting and supporting growth. So I think that again, the strength that we've had, we have the ability to do those things. If the question is around what are we seeing from some of the enterprise customers, and Ken is seeing a lot of this as well, do we see deals that go from five years to three years? Sure. Is it more than we've seen in the past? I'd kind of look back at the contract term data point that we gave and say maybe, but not a lot kind of a thing. And on payment terms, the channel has always offered a financing function. I think they prefer to provide the financing function and then I think we provide support to the financing function to the channel by making capital available to them through payment terms.

Ken Xie:

Yes, we are, overall we look at both headcount and headcount cost, probably the same pace, company grow the top line, and also try to, at the same time try to improve in some efficiency there. So we're now looking for headcount growth above the top line, even with few, there's a few some question in the area. We also need to do some more investment, on time investment. But companies so far, we feel we have a pretty healthy finance model and this also could be the opportunity to also gain in some market share.

Ken Xie:

Thank you.

Ittai Kidron:

Thanks guys, and nice results. My first question I guess is on the U.S. enterprise, so not U.S. in general, but just the enterprise vertical, clearly one of the most important growth opportunities for you long-term. Can you talk about progress over there, win rates displacements, and is the macro making things easier or more difficult for you specifically in the U.S.?

Ittai Kidron:

Okay, thanks. And then maybe followup on the competitive side and Ken, maybe you can talk about what have you seen out of your competitors in the U.S. and kind of abnormal activity from discounting or otherwise?

Keith Jensen:

Yes, I would think that with, when Ken talks about the figures is fantastic. I think keep in mind, we don't, we have a very, as we kind of talked about prepared market, a very diverse customer base, if you will, between being international, between being very large, mid, small, and MSSPs, et cetera. So I don't want put a policy in place that covers every geography and it covers every customer size. And I think what you're really talking about here is something that for us represents 15% of our business, maybe just a little bit less. And because it's at that size, it's something that we can really more, I think, target our responses to as we get deeper into the selling function as opposed to some broad announcement that we're going to give away services for two years or something like that.

Operator:

Thank you. One moment for the next question. This question comes to the line of Angie Song with Morgan Stanley. Your line is open.

Ken Xie:

It's a pretty strong growth. And also we're working with a lot of our service providers, both on the infrastructure side or our security service side, and offer the SASE because we do believe SASE should be a ecosystem with a lot of player instead of just a vendor offer their own SASE. Because a lot of I'd say probably most the customer, they prefer some of their data in process controlled themselves whether some privacy SASE or some data sovereignty, keeping the data within certain geo. So that's where we see the SASE approach, we call universal SASE gave the customer flexibility to offer both cloud based on primary space or kind of leverage service providing infrastructure will be more benefit for industry long-term. So that's where -- even sometime we kind of take a little bit more time to develop all the SASE function in the single always. But that's making more easy for the customer, for the service provider to deploy SASE to fit their need at their environment. So we see a very, very healthy pipeline and the strong growth kind of our salary growth. And that's also based on kind of a more healthy margin kind of model instead of do see money, all of our growth. So we want to maintain that model and also working closely with our partner to offer kind of a SASE together to the customer.

Keith Jensen:

Angie, can you repeat that? You cut out in the beginning of that question.

Ken Xie:

We see the midterm model would be $10 billion building by 2025 and with non-GAAP operating margin at least 25% for each year in the next three years.

Keith Jensen:

Yes, I think the one thing, Angie, and I think answer about this before as well, keep in mind, two-thirds of the business roughly is service revenue. And that's producing a gross margin that's in the mid-80s. So, and that's, those are longer-term contracts. So I think the business model is such that we'd have time to react if there was something really dramatic that happened in the industry. But part of that's, for that to happen, I think you'd probably have to see some sort of shift in the behavior of the bad actors, the nation states, the organized crime groups, et cetera. And we don't see that's on the landscape.

Operator:

Thank you. [Operator Instructions] This next question comes from the line of Tal Liani of Bank of America. Your line is open.

Keith Jensen:

Yes. So as a reminder, Tal good to hear from you again, if you think of the business being, extremely diversified, whether that's geographically or by customer segments, one-third small, one-third mid, one-third large. We specifically called out in the script that we added over 6,000 new logos in the quarter. So obviously and that's probably a growth rate that's, easily into double digits. New logos take a while to really produce revenue for us, it tends to be, less than 10% of total revenue from the new logos. So it creates the opportunity to continue to sell into them. Kind of to Ken's comment a moment ago into your question here, do we see large enterprises in the U.S. still moving forward robustly with all their various digital transformation projects? I think that the, the word on the street is, that slowed down a little bit. And in that environment, I do think that incumbents sometimes have an advantage, but also a cost of performance argument and debate is something that you see customers perhaps more receptive to in the current macro environment

Keith Jensen:

It was flat year-over-year down one month, quarter-over-quarter.

Keith Jensen:

Which somebody reminds me of the room very politely. Every first quarter is down one month.

Operator:

Thank you. One moment for the next question. This question comes from the line of Andrew Nowinski of Wells Fargo. Your line is open.

Ken Xie:

Yes, SASE definitely is the one the, the use case especially the universal SASE or sometime they called a private SASE for some customer, they some service provider, they want to have a more control of their data. So that's we see is both SASE like the service model, customer benefit service provider has a big value-added that one, but at the same time gave the flexibility of what your full of force some traffic to the cloud or to the pop or have a process on premise and by the appliance. So that's, we see the huge benefit of universal SASE solution, which is very different than some other SASE player and a lot of customers and the partner were interest to at this universal SASE approach.

Keith Jensen:

Well, Ken and I are smiling at each other. We've had this conversation that they're I think I've been here for nine years as of this week. One thing I've come to appreciate is that Ken behaves like a long-term investor, and with that in mind owning critical real estate assets tends to have a better payback than leasing them over an extended period of time. Whether that's in R&D facilities, whether that's in manufacturing or warehouse facilities, or that as you, as we move into that, into the SaaS market as well as other cloud offerings it's not just investments in SASE, if you will, but it's also investments in larger data centers in order to deliver various, cloud-based services and solutions. And I think you've heard us talk about that the last several earnings calls and the guys of, data centers having an impact on margins for services and CapEx spending. So I don't think there should be a surprise there, but I think it is a, an indication of our looking to expand into, more fully into some of these other markets.

Operator:

And thank you. One moment for our final question. Our last question comes from the line of Shrenik Kothari from Baird. Your line is open.

Keith Jensen:

Yes, I would say it's all the above. It's happening geographically. I think it's happening with customers that we took down earlier that are expanding with us, with additional firewalls and additional security or additional services as well. I think the market, if you will, financial services, if you step back and look at what's happening there, specifically the firewalls over the last several years, there's probably two legacy vendors there that when they're contracts are up for renewal and we've talked about this for a long period of time, now they're exposed. And it creates an opportunity to come in for a competitive displacement. And I think that some of the other comments or questions today is, is it more difficult in this environment for competitive placements? I mean, sure, you got to work a lot harder to make it happen. You got to make your value proposition more well known. But I think, again I think it's expansion. I think it's opportunity to displace incumbents and I don't think it's specific to any one particular geography.

Shrenik Kothari:

Got it, got it. Thanks a lot, Ken, Keith just a quick follow-up. And you guys, of course, started upon the expansion opportunity in the form factors. Of course, your peers and parties have spoken about unit expansion pressure and how the product unit growth is kind of normalizing. But just wondering, given that give examples of this 8-figure expansion and upsell opportunity replacing kind of firewall with a holistic solution. Can you talk about like expansion drivers broadly like – are you seeing mostly upsell and expansion in form factors versus the units? Just imparted to get some clarification there.

Shrenik Kothari:

Got it. Thanks a lot. Ken, I appreciate it.

Operator:

Thank you. That concludes the Q&A segment. I'll now turn it back over to Peter Salkowski for closing remarks.

Operator:

And thank you for your participation in today's conference. This does conclude the program. You may now disconnect.

Peter Salkowski:

Thank you, Valerie. Good afternoon, everyone. This is Peter Salkowski, Senior Vice President of Finance and Investor Relations at Fortinet. I'm pleased to welcome everyone to our call to discuss Fortinet's financial results for the full-year and fourth quarter of 2022. Speakers on today's call are Ken Xie, 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 then review our financial and operating results for the full-year and fourth quarter of 2022 before providing guidance for the first quarter of 2023 and the full-year. We'll then open the call for questions. Before we begin, I'd like to remind everyone that on today's call, we will be making forward-looking statements, and these forward-looking statements are subject to risks and uncertainties, which could cause actual results to differ materially from those projected. Please refer to our SEC filings, in particular, the risk factors in our most recent Form 10-K and Form 10-Q for more information. All forward-looking statements reflect our opinions only as of the date of this presentation, and we undertake no obligation and specifically disclaim any obligation to update forward-looking statements. Also, all references to financial metrics that we make on today's call are non-GAAP unless stated otherwise. Our GAAP results and GAAP to non-GAAP reconciliations are located in the earnings press release and in the presentation that accompany today's remarks, both of which are posted on the Investor Relations website. Ken and Keith's prepared remarks for today's earnings call will be posted on the quarterly earnings section of our Investor Relations website immediately following the 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 Xie.

Keith Jensen:

Thank you, Ken, and good afternoon, everyone. As we look back at 2022, we see the success of our strategy to lead in convergence and consolidation as well as the combined power of our ASIC technology with our integrated operating system. Combined, these efforts are driving our strong financial results. There's been an explosion of devices that must be connected to the cloud, data center and edge compute. As a result, the infrastructure has expanded to support secure connectivity via distributed firewalls, it is no longer feasible to overlay security on top of networking in the data center. They must be deployed as a converged solution. Firewalls need to work seamlessly with networking and security applications across the company's entire infrastructure. Fortinet is leading the convergence trend with a wide range of technologies, including network firewalls, Secure SD-WAN, 5G and OT security, all embedded in our single operating system delivered as hardware, software, cloud and as a service. Traditional CPU-based solutions are very inefficient as supporting both networking and security. That's why Fortinet developed proprietary ASIC technology to build an application-specific solution. Yesterday, as Ken mentioned, we announced our next-generation ASIC, the FortiSecurity processor or FortiSP5, which allows line speed convergence of networking and security at every network edge. The new seven nanometer technology combines existing NP7 technology with new content processor capabilities. Our enhanced platform suite of integrated products is delivering on customer demands for convergence, vendor consolidation, ease of management and lower operating costs. The success of this strategy is evident in our full-year 2022 results, and I'll start there. Billings passed the $5 billion mark, totaling $5.6 billion and growing 34%. While revenue totaled $4.4 billion, with growth accelerating to 32%, the fifth consecutive year of revenue growth of 20% or more. Driven by strong demand for our fabric and cloud security solutions, enhanced platform technology billings and revenue both increased over 40% to $1.8 billion and $1.5 billion, respectively. And despite a challenging global supply chain environment, product revenue growth came in at 42%, our highest annual product revenue growth rate in over 10 years. Our product revenue growth was driven by the combined -- by the continued growth of our firewall use cases and the addition of over 23,000 new customers. Service revenue was up 26% to $2.6 billion, resulting in three consecutive years of accelerating service revenue growth rates. Gross margin was strong at 76.3% and operating margin outpaced our initial expectations, increasing 110 basis points to a new Fortinet record high of 27.3%. Our GAAP operating margin of 22% is one of the highest in the industry, and we continued our streak of being GAAP profitable every year of our 14-year history as a public company. Earnings per share increased 49% to $1.19. Free cash flow was a record at $1.45 billion. Free cash flow margin was 33% and adjusted for real estate investments, the free cash flow margin came in at 37%. And for the year, we repurchased approximately 36 million shares at a cost of $2 billion. Total deferred revenue increased 34% to $4.6 billion. Short-term deferred revenue increased 32% to $2.35 billion. Quarterly contract terms throughout the year were consistent with the year earlier periods, including the fourth quarter at 28 months. Before moving on to our Q4 results, I'd like to summarize our enterprise success and highlight a few seven figure deals from 2022. We saw great success during the year with our strategy to expand further into the large enterprise segment as the number of deals over $1 million increased over 55% to a record 546 deals and billings on these deals increased by over 70%. If we look at a few of our large deals of the year, let's start with the competitive upsell deal, Fortinet displaced a 11 different vendors by consolidating the customer's network to security functions on our Security Fabric. This worldwide wholesaler previously purchased secure SD-WAN and FortiProxy. Next on the list was a centralized network security solution that could be managed and deployed to its 400 global locations. This customer chose Fortinet Security Fabric for a selectable and integrated solution across multiple scenarios, including work from anywhere, perimeter security and data center segmentation. In another upsell deal, a leading global manufacturer was spun off and had to stand up the security and networking infrastructure separately. The newly created infrastructures included remote access, SD-WAN, application delivery control, authentication, endpoint, e-mail protection and switching. Keys to our win included our Zero Trust capabilities, a cloud-first SD-WAN strategy and the ease of integration and convergence across our platform suite. Lastly, in the new logo win, a large U.S. retailer with over 500 locations were struggling with a total cost of ownership of their legacy security architecture. Keys to this win included delivering a single pane of glass versus the multiple consoles they were using and replacing the competitors' firewalls with our FortiGate's, delivering URL filtering, WiFi security, and edge router replacement, all on our unified and integrated FortiOS platform. This customer reported anticipated savings of $29 million over five years. Turning to Q4 results, both billings and revenue delivered new Fortinet records with billings of $1.7 billion and revenue of $1.3 billion. Both metrics increased over 30%. The strong fourth quarter revenue performance reflects solid customer demand across both our core and enhanced platform technologies. In the fourth quarter, we added over 6,200 new logos, another new Fortinet record reflecting the support of our channel partners, the leverage they bring and the breadth of our worldwide customer base. Taking a closer look at the fourth quarter, billings growth of 32%, was driven by a 40% increase in enhanced platform technology billings, which accounted for over one-third of total billings. Total revenue growth of 33% was driven by a strong demand for core and enhanced technology platforms, which increased 26% and 47%, respectively. Product revenue grew 43% to $540 million. Service revenue was up 27% to $743 million, driven by strong product revenue growth and strength in our security subscriptions. Short-term deferred revenue grew 32% and represents eight consecutive quarters of accelerating growth rates. Total gross margin of 77.6% was driven by a 310 basis point increase in product gross margin to 65.2%. Several factors converged to drive our record high quarterly product gross margin, including legacy pricing actions, easing supply chain cost pressures and improved discounting. Service gross margin of 86.7%, ticked down 40 basis points due to increased labor cost and our expansion in cloud services and the related hosting costs. Operating margin of 32.5%, was up 400 basis points year-over-year due to the strong gross margin performance and FX benefit. Looking to the statement of cash flow summaries on Slides 11 and 12. Free cash flow was $497 million, adjusted free cash flow, which excludes real estate investments was $510 million, representing a 40% adjusted free cash flow margin. Cash taxes were $63 million, capital expenditures were $31 million, including $13 million for real estate investments. DSO increased 14 days sequentially and year-over-year to 89 days, also impacting service revenue growth. Moving to guidance. We believe the continued innovations we made in building our platform enables our customers' digital transformation journey. And as Ken noted, customers are increasingly recognizing how Fortinet is integrated and single platform approach to security can deliver a lower total cost of ownership and a greater return on investments than competing solutions. Now I'd like to review our outlook for 2023, summarized on Slide 15, which is subject to disclaimers regarding forward-looking information that Peter provided at the beginning of the call. For the first quarter, we expect billings in the range of $1.415 billion to $1.465 billion which at the midpoint represents growth of 24%. Revenue in the range of $1.180 billion to $1.220 billion, which at the midpoint represents growth of 26%. Non-GAAP gross margin of 75% to 76%; non-GAAP operating margin of 23% to 24%, which at the midpoint represents an increase of 150 basis points. Non-GAAP earnings per share of $0.27 to $0.29, which assumes a share count of between $795 million and $805 million, capital expenditures of $80 million to $110 million, non-GAAP tax rate of 17%, cash taxes of $20 million. And should also note that first quarter guidance assumes backlog decreases slightly during the quarter. For the full-year, we expect billings in the range of $6.710 billion to $6.790 billion, which at the midpoint represents growth of 21%. Revenue in the range of $5.370 billion to $5.430 billion which at the midpoint represents growth of 22%. Total service revenue in the range of $3.335 billion to $3.365 billion, which at the midpoint represents growth of 27%, it implies a fourth consecutive year of accelerating service revenue growth. The service revenue guidance also implies product revenue growth of 15%. Non-GAAP gross margin of 75% to 76%, non-GAAP operating margin of 25% to 26%, non-GAAP earnings per share of $1.39 to $1.41, which assumes a share count of between $805 million and $815 million. Capital expenditures of $400 million to $450 million due to continued investments in clouds, data centers and facilities. Non-GAAP tax rate of 17%, cash taxes of $375 million, split somewhat evenly between the first and second half of the year. The increase in cash taxes reflects recently effective R&D capitalization and amortization requirements. The full-year estimate assumes backlog approaches historical levels by the end of the year. Cybersecurity, but not immune to economic slowdowns is expected to remain a comparatively safe harbor. And with a strong business model and history of execution, we are confident that our market share gains will continue. We remain on track to achieve our 2025 financial targets, which include billings of $10 billion, revenue of $8 billion, non-GAAP operating margin of at least 25%, and adjusted free cash flow margin in the mid to high 30% range in 2025. And with that, I'll now hand the call back over to Peter to begin the Q&A session.

Operator:

Thank you. [Operator Instructions] Our first question comes from Brian Essex of JPMorgan. Your line is open.

Ken Xie:

I took a question feedback from some customer partners. Their budget is tight, but Fortinet solution has a better cost of total cost ownership and also kind of even cost saving for some like a Secure SD-WAN solution. And at the same time, we do see -- the use case of firewall expanding much broader than before, especially for this OT security, some other area, which pretty much, I'd say, network security may be the only solution to secure some of this OT area. So that's where we see the demand is still pretty strong. And so we probably -- we're keeping gaining more market share in this well fragmented market.

Brian Essex:

Got it. Maybe just for a quick follow-up then, Keith. As you think about the level of conservatism in your fiscal '23 guide, I mean, stronger than, I think some had expected. I know I'm going to get the question tomorrow how much conservatism is in there. What gives you confidence in hitting that kind of level of performance, particularly with regard to billings. And then any change to your 2025 targets as you kind of look at the strength that you're seeing in the market from here on out?

Brian Essex:

Okay, that's super helpful. Thank you very much.

Fatima Boolani:

Hey, good afternoon. Thank you for taking my questions. Keith, for you, just with respect to the services revenue guidance at 27%. That's not a material difference from the cadence you've been running at this year. And I'm curious what sort of input embed that revenue segment for you? And I ask because we have the dynamic of some of your customers delaying their subscription registrations over the course of '22. And then we also have the dynamic of a lot of your customers not having realized the pricing increases that you've expected in the last 12 to 18 months. So I'm curious as to why with those positive inputs, you -- we wouldn't see better services growth. And what sort of things that you're being conservative about there? And then a quick follow-up, please.

Fatima Boolani:

Understood. And any commentary on operating margin and operating profitability performance because we are seeing compression into next year, certainly on a quarterly basis. But anything to be mindful of there as it relates to maybe onetime items that are peeling out just perhaps why not see better follow-through in profitability? And that's it for me. Thank you.

Operator:

Thank you. One moment please. Our next question comes from the line of Saket Kalia of Barclays. Your line is open.

Ken Xie:

I think there is two parts. First, I totally agree with you said that SD-WAN and the OT market growing faster than the network security average. And on the other side, we do believe our solution has huge advantage compared to other competitors. So both SD-WAN, OT market is still pretty fragmented and compared to our home growth integrated solution and leverage for the ASIC company and power. So advantage much huge compared to other competitors, quite some mostly come from acquisition. And at the same time, they don't have the ASIC help to increase speed, lower the cost and the power consumption. So that's why we feel we're keeping growing above the market, so above the market growth rate. There's a different research about how the market is growing. But I do agree it's a fast-growing market compared to the cybersecurity space and there will be a lot of potential going forward.

Keith Jensen:

Yes. I don't think that we've really seen customers push on the term. Obviously, at 28 months -- 28 months, which is kind of been keeping where we've been historically. But I do think in the fourth quarter, we certainly had conversations with customers that were I think perhaps even more focused on cash flow, if you will, than they were on discounting in terms of extended payment terms and that sort of thing. So if I were to look at the -- what I'm hearing back from customers, it was all about cash protection. And with that, I assume if I were trying to do a lot of five-year deals or something like that, I might have felt more pressure. But given the SMB mix of our business and our partner footprint, obviously, didn't come through in the numbers really.

Operator:

Thank you. One moment please. Our next question comes from the line of Hamza Fodderwala of Morgan Stanley. Your line is open.

Keith Jensen:

Yes. We did see a pickup to if we want to call it mid-single digits in Q3, we saw it tick up to high-single-digits in fourth quarter -- in the fourth quarter. And we've anticipated this, particularly as the backlog starts to shift its mix as the firewalls. There's still a significant amount of firewalls in the backlog, but it really now has tilted towards the network equipment, the switches and the access points. And so as you would expect, one last comment on that, as we see the shift in the mix in the backlog as well as the pick-up in the cancellation rates, I would also offer that as part of the guidance setting process, I think we've taken a fairly conservative approach to cancellation rates on what they -- how they may impact 2023 or said another way, we're not expecting all the backlog that exists at the beginning of the year to convert in 2023 because we think there'll be some cancellations.

Ken Xie:

Definitely more service, whether under the overlay service for SD-WAN because our SD-WAN has all the security function and also a lot of -- deployed case whether supporting work from core from anywhere or kind of helping enterprise reduce their total cost of networking all these things. We do see a lot of additional service they need. At the same time, we also see the service provider starting more working together with us, offer some quite additional service beyond -- that's the traditional SD-WAN. So that's also helping drive much more service going forward.

Operator:

Thank you. One moment please. Our next question comes from the line of Brad Zelnick of Deutsche Bank. Your line is open.

Ken Xie:

Probably want to take some time, I'd say, maybe one to two years to refresh the product. And that's where every quarter, we tend to release one or two products, whether leverage new ASIC or the new CPU of Smarter network chip in the industry. I don't feel it will be a significant impact up and down of the result and will be more smooth transition. Because security deployment is a kind of a -- take long time to design, evaluate, deploy and also very, very long sales cycle. At the same time, the life cycle of the product also tend to be quite long, like seven to 10 years. So that's where the ASIC each generation definitely will help in and at the same time has a huge advantage compared to using general-purpose CPU. So that's where we're keeping gaining market share. But consider the switching costs, consider the long cycle, sales cycle and deployment cycle. And also, we also need time to put ASIC into a new product, which also taken in a few months, three to six months, thus I do see it will be like a more long-term positive impact instead of short-term.

Brad Zelnick:

Thanks for the reminder and Keith, can you just expand on your comments around DSOs being up sequentially year-on-year and the impact of services revenue? And related to that, I recall you had a change in policy around subscription activations. Is that also impacting services revenue. Any help there would be great. Thanks.

Operator:

Thank you. One moment please. Our next question comes from the line of Shaul Eyal of Cowen. Your line is open.

Keith Jensen:

Yes. I think that we kind of remain truthful to or faithful to the notion of providing service revenue guidance for the full-year and kind of leave the Street work out the numbers from that point going forward. I think that certainly, as we kind of look at laying out the year and with the backdrop of the macro that we're all concerned about, I don't think we really wanted to push too hard on some of the metrics that we didn't need to push on. And I think where we ended up with is pretty consistent in the quarter with our consensus when we look at our internal allocations between product and service revenue.

Keith Jensen:

I'm going to answer yes. Yes, you should be thinking about one of those two ways. Look, I think we're driven by being above 25% operating margin, right? I think the ones that -- the last few years have taught us is life full of surprises. And so locking into a fixed commitment is a little bit challenging sometimes. But clearly, we manage the business as if it's the floor.

Operator:

Thank you. One moment please. Our next question comes from the line of Adam Borg of Stifel. Your line is open.

Ken Xie:

Yes, we are continuing hiring. But at the same time, we want to keeping the efficiency and is not dropping the efficiency for the sales and marketing. And at the same time, there's some long-term investment, whether in R&D, the infrastructure supporting, we will continue to need to make. So that's why we do expect the total head count will keep it increased, but probably the rate that just like the last few years will be below the top line increase.

Adam Borg:

Got it. And maybe just a quick follow-up just on the FortiGate and entry mid and high. It's nice to see really strong midrange growth is interesting at the high end leased by my math was the lowest mix since 2017. Just curious if anything to comment there. Thanks so much.

Keith Jensen:

Yes. I think that's one of the challenges you have in the current environment and the supply chain was really doing funny things, if you will, into delivery, and we don't give you a lot of insights to orders that we were taking in, but we provide billings numbers, you get some distortion there just simply based upon what's available. Specifically, we saw a significant amount of availability of the 100F products, if you will, which are a midrange product. And you're seeing that availability came in the fourth quarter, and it shifted that mix in the way you just described it.

Tal Liani:

Hello. Thank you. There's going to be one day call that no one is going to butcher my name, and I'm going to be very happy. But I wanted to ask you two things. First of all, could you provide a backlog for 4Q or anything about it? I'm trying to calculate the bookings for the year and what happens to bookings? And any color on backlog would be great. And the second question, a few people asked you about the services growth for next year. I want to ask you about the product growth. The product growth is going from 42% to 15%, if my math is right, from last year to next year to this year. And on the other hand, your commentary is positive. It's -- there's more activity, there's more product sales. So can you take us through the dynamics of product growth and also the connection, the relationship between services and products. Thanks.

Ken Xie:

Yes, I think for the backlog like what I said in the last one or two quarter, it's continued shifting to the network area, network and the Wi-Fi which is more industry standard product. I'd say probably today, most of the backlog will come from the network side and the Wi-Fi side, which has a higher cancellation rate. And -- so that's where like Keith has mentioned, we take a pretty, when it's positive conservative, but that definitely pretty good estimate what will the impact for the whole year on all these -- the backlog for the product revenue. And product revenue, definitely, we see probably going forward, the benefit of the new ASIC and also some of the new products that were helping and also some of the case, the use case -- additional use case of the firewall definitely also are helping, but it will take some time. So that's where we tend to be more careful to forecast. At the same time, we do see long-term, we still have a huge advantage compared to other competitors because the investment we made in the product, in the hardware, in ASIC give us huge advantage of the total cost of ownership towards container keeping gaining market share in that space.

Ken Xie:

I think it's -- since it's been a large difficult to forecast at the same time, with the change in cancellation and also most of the backlog related to networking WiFi not a core product. So that's where, since last quarter, we no longer provide detail of the backlog, we feel that could be a little bit misleading if we keep in providing that.

Tal Liani:

Got it. Thank you.

Ittai Kidron:

Thanks. Hey guys. Nice quarter. Keith, I was wondering if you could do a little bit of a deeper dive for us into the enhanced part of your business, if there's a way for you to kind of break it down a little bit for us by product. And perhaps rank order for us, categories which are growing above the average for the category and below the average for the category. I would just like to get a little bit more color as to the change in mix within that?

Ittai Kidron:

Got it. Excellent. And then just going back to the cancellation rate, just to make sure I understand this. How much of this is tied into supply chain, meaning of supply chain? Is it getting better availability is no longer an issue? Customers are less perhaps interested in getting too far ahead in line and waiting for product. How much of that is a factor in this?

Keith Jensen:

Yes. I think the conversation around cancellation rates, a few things there. We said it went from mid single-digits to high single-digits. And then as we built into the guidance, it is a multiple that we built in the guidance of what we just saw in the fourth quarter. What we actually get out of it, we'll see. But the reason to be so cautious about it is what Ken is talking about. We knew that we had an advantage with firewalls and dealing with our suppliers and our vendors and we thought we'd be successful in pushing down that component of backlog first. And indeed, the mix has shown that. I think it's now something on the order of about 75%, 25% between networking equipment and firewalls still firewalls in the mix. But as Ken pointing out is there may be more risk with that networking equipment of cancellations as we go forward, and particularly its a backlog deal for those elements continue to age out a little bit as we move through this process. In terms of continuing supply chain challenges, I'm not quite sure I was making the length on that. I don't -- I guess that would have an impact on the continuing to build of backlog. But as we said in our comments, we really expect to get to a backlog number by the end of this year that's much more closely aligned with our historical norms.

Operator:

Thank you. One moment please. Our next question comes from the line of Andrew Nowinski of Wells Fargo. Your line is open.

Ken Xie:

I think we definitely have a pretty long tenure and a good team there. And at the same time, the case, the firewall case also expand quite well in Europe, in some countries there. And some of the service provider carrier, they are a little bit more ahead compared to some bigger service provider were the U.S. on moving some new solutions, including some 5G SD-WAN. So that's where we continue to see some good growth there. Also, we kind of surprisingly even during the recession, the SMB sector growing quite strong compared to some enterprise. Enterprise more about how to lower the cost ownership, protect some of their own kind of profit margin. But SMB, they do see the importance of cyber security, especially in retina were they are starting more targeted SMB right now. So we do see quite strong growth in SMB and so that's also helping some regions in Europe.

Keith Jensen:

Yes. I think a few things we talked about price benefits, the discounting and then some easing of the impact of the supply chain. I think the price benefit is something that will obviously stay with us in the future. And so we should still get a tailwind from that. However, discounting and supply chains, call it, savings for lack of a better term, that's what we relate to our history of price increases. And I think we kind of reached a very kind of maybe the high watermark in terms of being -- having price increases covering those costs, and that will start to settle back down to a more normalized pattern going forward. Meaning that we'll still have inflationary cost increases, but we've really slowed down the price benefits, the price increases. So net-net, price increases continue, discounting and supply chain benefits may not.

Operator:

Thank you. One moment please. Our next question comes from the line of Raymond McDonough of Guggenheim Partners. Your line is open.

Ken Xie:

I think in the 2014, 2015 last the outbreak of a weather target so many case, which a lot of enterprise tried to upgrade from the traditional connection-based firewall to the next-gen firewall, which including some prevention and other things. So that's where it's more like kind of refresh more in the enterprise area. So we do see some strong growth there after the severe issue. And then by this time, we see there's a few things. One is really during the pandemic, there's a new infrastructure build supporting a homework anywhere. At the same time, the ransomware attack quite broadly hit the whole industry. And another part, we keep on seeing the convergence, which is like SD-WAN, the 5G, the WiFi and also internal segmentation. So that's a much broader used case of the firewall deployment and also including OPG, a lot of more devices being connected. So we feel this time it is really kind of a more broad firewall used case kind of apply to the whole infrastructure. That's what we kind of more emphasized the convergence is a little bit different than the last time it's like eight, nine years ago. So that's why we feel this time probably will be more smooth transition because the traditional firewall, whatever will not go away. And at the same time, that's more used case convergence into the traditional networking area, expanding to the OT some other area, we're helping keeping driving the product revenue growth and then followed by the additional service revenue. So that's the chance we're planning.

Ken Xie:

Yes, it's definitely helping the customer lower the total cost of ownership, both on the management cost and also on the product service cost, which we have here an advantage over the competitors. So that's where we see a lot of a big enterprise customers. They definitely want to -- when they see the renewal, when they see all this -- need to add additional protection for the infrastructure, we do see this like how to have a better total cost of ownership and at the same time, leverage a single integrated platform, automated platform to offer better security networking together. Even there's a trend to merge the traditional network operating team and security operating team together to making the stock and not kind of combined together and also converge on the traditional networking and security together. So we do see some trends happening in the big enterprise and which we kind of developed technology and the long-term investments starting to see. I mean, stating benefit for the trend.

Raymond McDonough:

Yes, go ahead.

Raymond McDonough:

Great. Thanks for the color and congrats on the strong results.

Adam Tindle:

Okay. Thanks. Good afternoon. Keith, I wanted to start with pricing. I think we picked up if we got this right, another pricing increase announced in January effective in February. Wondering if you could touch on the rationale and early response to that -- where are we in the elasticity of demand? And thinking forward, obviously, costs are ultimately going to normalize, hopefully, in your model. What would be the strategy for you once costs normalize, would you reduce price or capture margin? Thanks.

Adam Tindle:

Got it. Okay. And then maybe just as a follow-up for Ken. I wanted to ask on SASE competition. When your main competitors has said they've integrated their SASE offering with SD-WAN and Secure Web Gateway in particular. They're pushing that sales motion across the entire sales force now. As we think about Fortinet, obviously, very strong in SD-WAN, but that Secure Web Gateway or proxy piece is perhaps not as prevalent or a different strategy. It's clearly not impacting your unit market share at present, but just thinking forward to competing and differentiating in SASE now that your competitor really pushing that motion across the entire sales force? Thank you.

Adam Tindle:

Very helpful. Thanks and congrats on the year.

Operator:

Thank you. One moment please. Our next question comes from the line of Ben Bollin of Cleveland Research. Your line is open.

Ken Xie:

Yes. We continue keeping building of the infrastructure, including the cloud. Also our strategy a little bit different than 100 players we tend to build out ourselves just like we -- you can see the investment in some of the real estate. Quite some of that also go to the -- like a data center infrastructure that give us much better cost and also more long-term benefit just like how we -- the investment made in early real estate kind of benefit our office cost, rental costs. So that's where we're using the cost saving we get from this rental keeping invest into some more long-term infrastructure real estate. We do see that we're keeping benefit the company a long time. But at the same time, like I said, also partner working with car service providers that's other strategy we have managed some of their infrastructure. So that's also make a win-win both party or benefit or will be profit. That's also the strategy we have.

Ken Xie:

Not just, but also will make it easy to manage easy to scale. Even some of the SASE solution I had to be the some bigger customers, they may even do themselves. So if you can integrate a more successive function to the same or into the same system. So that's sort of the long-term strategy we have and also working with service providers is very, very important for us.

Ken Xie:

That's kind of the thinking we have like over 20, 30 years really. There's a convergence of networking, traditional networking and network security. I think SD-WAN is a very, very good example. So the WAF solution will be more efficient, more secure, and there's a lot of additional service we can apply to secure SD-WAN, which is whether offer free or we are not kind of there yet. But same thing for a lot of other web technology. And so we feel that's a huge potential. And -- but also doing security in the networking environment not need a huge company in power, which has come from ASIC investment we made, which also will take a long time to see the return of investment, that's what we kind of comment from day one back 23 years ago. So when we start with we really need to invest and planning all these kind of long-term convergence of networking or security together. So the new ASIC is one example is the fifth generation of our SoC chip, which also including some of the investments we made in the mine generation of our content process and seven-generation network processor together with a lot of multiple CPU. So we continue to develop technology and eventually will be deployed more broadly beyond the traditional network security.

Peter Salkowski:

Thank you, Valerie. I'd like to thank everyone for joining today's call. Fortinet will be attending investor conferences hosted by Baird and Morgan Stanley during the first quarter. A fireside webcast link will be posted on the Events & Presentations section of Fortinet's Investor Relations website for the Morgan Stanley conference. If you have any follow-up questions, please feel free to contact me. Have a great rest of your day. Thank you.

Peter Salkowski:

Thank you, Eric. Good afternoon, everyone. This is Pete Salkowski, Vice President of Investor Relations at Fortinet. I am pleased to welcome everyone to our call to discuss Fortinet’s fiscal results for the third quarter of 2022. Speakers on today’s call are Ken Xie, Fortinet’s Founder, Chairman and CEO; and Keith Jensen, our Chief Financial Officer. It’s a live call that will be available for replay via webcast on our Investor Relations website. Ken will begin today’s call by providing a high-level perspective on our business, then follow our – with a review of our financial and operating for the third quarter, providing guidance for the fourth quarter and updating the full year. We’ll then open the call for questions. During the Q&A, we ask that you please limit yourself to one question and one follow-up question to allow others to participate. Before we begin, I’d like to remind everyone that on today’s call, we 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. All forward-looking statements reflect our opinions only as of the date of this presentation, and we undertake no obligation and specifically disclaim any obligation to update forward-looking statements. Also, all references to financial metrics that we make on today’s call are non-GAAP, unless stated otherwise. Our GAAP results and our GAAP to non-GAAP reconciliations are located in our earnings press release and in the presentation that accompany today’s remarks, both of which are posted on the Investor Relations website. Ken and Keith’s prepared remarks today for today’s earnings call will be posted on the quarterly earnings section of the Investor Relations website immediately following today’s call. Lastly, all references to growth are on a year-over-year basis unless noted otherwise. I will now turn the call over to Ken.

Keith Jensen:

All right. Thank you, Ken, and good afternoon, everyone. Let’s start with an overview of our strong third quarter performance. Revenue of $1.15 billion was another quarterly record for Fortinet, increasing 33% year-over-year and 12% sequentially; our highest third quarter sequential growth rate in eleven years. We continue to deliver better than industry average top-line growth and generate strong profitability. Our operating margin exceeded guidance at over 28%, driving the adjusted free cash flow margin to 40%. Our history as a public company has revolved around the Rule of 40, measured as the combined total of revenue growth and operating margin. Impressively, the Q3 total came in at over 60. We continue to see success in our strategy for expanding further into the large enterprise segment. The number of deals over $1 million increased over 80% to 153 deals. The total billings value of deals over $1 million more than doubled driven by a record number of deals over $5 million, and G2000 bookings increased over 40%. Our strong third quarter results reflect solid customer demand across both our Core and Enhanced Platform Technologies and the exceptional performance of the team in a challenging supply chain environment. We believe the investments we’ve made in building our platform and our go-to-market engine enables our customers’ digital transformation journey. Our platform strategy allows customers to converge networking functionality with security capabilities while consolidating cybersecurity products, providing security across their entire digital infrastructure while lowering their operating costs. Recently, the Forrester Wave Enterprise Firewalls report acknowledged the success of our investment strategy, placing Fortinet as a leader for the first time in its history. According to Forrester, “Fortinet excels at performance for value and offers a wide array of adjacent services. Long known for its bang-for-the-buck approach to network security, Fortinet has built a flexible and capable platform with its flagship product, the FortiGate Firewall." Taking a closer look at the income statement, product revenue grew 39%. Product revenue growth for our Core and Enhanced Platform Technology products increased 29% and 51%, respectively. The product revenue growth rate accelerated over 4 points sequentially, especially impressive given it is our toughest year-over-year comparison in over 10 years. Service revenue was up 28%, accelerating 3 points sequentially driven by strong product revenue growth and seven consecutive quarters that increased our term deferred revenue growth rates. Support and related service revenue was up 28%, accelerating over 2 points sequentially to $311 million. While security subscription service revenue was up 29%, accelerating 4 points sequentially to $370 million. Total revenue in the Americas increased 34%. EMEA revenue increased 37% and APAC posted revenue growth of 23%. Total gross margin at 76.2% exceeded the high end of our guidance range. Product gross margin of 61% was up 30 basis points year-over-year. Services gross margin of 86.6% was flat year-over-year, but up 70 basis points sequentially. Operating margin of 28.3% was up 250 basis points, benefiting from FX and the operating margin leverage that comes with higher revenues. Shifting to billings. Billings of $1.4 billion were up 33%, representing the sixth consecutive quarter of billings growth in excess of 30%. Core platform billings were up 27% and accounted for 67% of total billings. As shown on Slide 6, we entry-level FortiGates posted very strong billings growth with the mix shifting 16 points in their favor, driven by demand and as we expected improved supply. Enhanced platform technology billings were up 45% and accounted for 33% of total billings, a positive mix shift of 3 points. Average contract term was flat year-over-year at 29 months. Looking at the statement of cash flow summarized on Slide 7 and 8. Free cash flow was $395 million. Adjusted free cash flow, which excludes real estate investments, was $464 million, representing a 40% adjusted free cash flow margin. DSOs were down five days sequentially while increasing 12 days year-over-year to 75 days. Cash taxes were $69 million. Capital expenditures were $88 million, including $69 million for real estate investments. We repurchased 10.2 million shares of our common stock 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 FortiGate Firewalls accounting for just one-third of total backlog. We expect fourth quarter ending backlog to be relatively consistent with the third quarter backlog as we are seeing early signs of a transition back to more normalized customer buying behaviors. Moving to guidance. The current environment favors a Fortinet style platform that offers integrated solutions and strong security capabilities and 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 9, which is subject to disclaimers regarding forward-looking information that Peter provided at the beginning of the call. And to start, as part of the Q4 guidance setting process, we considered several factors, including the greater macro uncertainty today and with it, the increased risk of forecasting the timing of certain larger transactions. The transition to more normalized customers buying behaviors, which means there is less of an emphasis on ordering to get a place online. And for comparison, in the fourth quarter of 2021, when supply was tighter, backlog increased over $120 million and contributed to 49% bookings growth. And lastly, elevated year early year top line comparisons that include certain onetime items adding a couple of points of service revenue growth and fully cycling the Alaxala acquisition. In response, we have slightly widened our top line guidance ranges. For the fourth quarter, we expect to again reach the Rule of 60. And with that, the key metrics include billings in the range of $1.665 billion to $1.720 billion, which at the midpoint represents growth of 30%. Revenue in the range of $1.275 billion to $1.315 billion, 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 $0.38 to $0.40, which assumes a share count of between $795 million and $805 million. We expect capital expenditures of $75 million to $85 million. We expect a non-GAAP tax rate of 17%. And for the full year, we expect billings and revenue growth to exceed 30% for the second consecutive year. Billings in the range of $5.540 billion to $5.595 billion, which at the midpoint represents 33%, revenue in the range of $4.410 billion to $4.450 billion, which represents growth of 33%. Perhaps for context, we should note at the midpoint, these full year billings and revenue growth rates are 3 points higher than the initial growth rates we provided in early February, despite the start of the war in Ukraine in late February, significant increases in interest rates and increasing uncertainty in the 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 billion to $2.655 billion, which represents growth of 27% and implies full year product revenue growth of 42%. Non-GAAP gross margin of 75% to 76%; non-GAAP operating margin of 26% to 27% at the midpoint a year-over-year increase of 30 basis points. And again, for context, at the midpoint, gross and operating margin expectations were 50 and 100 basis points above the February guide, respectively. Non-GAAP earnings per share of $1.13 to $1.15, which assumes a share count of between $800 million and $810 million. We expect full year capital expenditures of $325 million to $335 million. We expect our non-GAAP tax rate to be 17%. We expect cash taxes to be $265 million. Before wrapping up, I’d like to offer some preliminary thoughts on 2023 and our midterm targets on the heels of a very strong set of growth in 2021 and in 2022. We continue to successfully balance growth and profitability, while investing in longer-term innovation and go-to-market initiatives to future growth. The strength of our business model includes its diversification, margins that provide capacity for future investment and a rich mix of higher-margin recurring service revenues. As we saw in the highs of pandemic, the diversification helps mitigate the risk of economic slowdowns. Specifically, in 2020, we delivered operating margins of nearly 27%, adjusted free cash flow margin of over 38% and top line growth of 20%. And during the past 12 months, we have really exceeded our target operating margin targets, while increasing our engineering headcount by about 20% and significantly increasing our future sales capacity by over 25%, including a greater than 50% increase in new, non-tenured, salespeople. While we will provide more detailed 2023 guidance when we report our fourth quarter results, it’s worth noting this 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 accelerating short-term deferred revenue growth. With a strong business model and the 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, the cybersecurity consolidation. Cyber securities are not immune to economic slowdowns is expected to remain a relatively safe harbor. As such, we remain on track to achieve all of our medium-term financial targets from our May 2022 Analyst Day, including $10 billion in billings and $8 billion in revenue in 2025, each representing a 22% three-year CAGR from the midpoint of our 2022 guidance. The targets also included an average non-GAAP operating margin of at least 25% for the four years from 2022 to 2025 and a 2025 adjusted free cash flow margin in the mid-to-high 30% range. Illustrating our long-term focus for balancing growth and profitability, our targets remain committed to the Rule of 40 or better. I’ll now hand the call back over to Peter to begin the Q&A.

Operator:

Excellent. [Operator Instructions] And our first question comes from Fatima Boolani at Citi. Fatima, your line is open.

Keith Jensen:

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. They were placing orders to get in line to hold their place in line for when the inventory is available. And I think I’ll say a year ago or so that, that was an appropriate behavior when there was a lot of uncertainty around the supply chain and maybe they’re planning what we’re 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 is that the – certainly, we are, but the supply chain is a little bit easier to forecast and somewhat easier to manage. I don’t mean by any stretch easy, but I do think it’s easier. And with that, I think you’re starting to see the market drift back towards the emphasis start to what I would call more traditional buying, which is when they need it, they’re placing the order.

Fatima Boolani:

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

Operator:

Okay. Thank you. Our next question comes from Saket Kalia at Barclays. Saket, your line is open. Please go ahead.

Keith Jensen:

Yes. I think Alaxala is probably the easiest one to talk about in terms of providing numbers. We’ve talked about the fact that their revenue stream was probably something in the order of $130 million to $140 million when we acquired them and reminded people that they are a March 31 year-end, so their fourth quarter is a little bit off cycle. I think that it’s growth single digits. So I think that probably gives people a good level expectation reminder there that our interest in Alaxala is a lot to run at the IP and some opportunities that we have there to do things more longer term, if you will. In terms of other unique things about product revenue in the quarter, I mean, I think that as the backlog comes into revenue as we go through the end of 2022 here and certainly into 2023 is tend to provide, again, a fairly significant tailwind to what the product revenue growth will be in 2023, assuming we get the drawn in backlog that we may see.

Saket Kalia:

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

Keith Jensen:

Yes. I would probably certainly agree with Ken operate just a little more detail on it. Keeping in mind that our – we sell in U.S. dollars, so there’s really not a direct FX impact there. On the revenue line, obviously, you can get into certain countries where the pressure on discounting, if you will, because of exchange rates can be a little more intense. But on the OpEx, because 30% of our business is in the U.S. and the rest is international. We do get a tailwind from OpEx from the strength of the U.S. And I think you’re 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%, so I think a floor of 25%. It has certainly served us well as a way to help other people understand about how we invest in the business, and as Ken makes reference to it. As we have funds available over that 25% operating margin, it creates opportunities for some, not necessarily all that you’re seeing currently of those margin dollars to be reinvested back in innovation and back into our go-to-market strategy.

Operator:

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

Keith Jensen:

Yes. I think I’ll come back to kind of Ken’s commentary around backlog, which is really what kind of drives the conversation about bookings. I think a year ago, when we introduced the backlog metric, there was a lot of uncertainty around what the supply chain crisis was going to look like and how it might impact our business and the purpose of providing the backlog disclosure and the booking disclosure then was to kind of round out and help investors understand more about our business model as we go forward. And as we heard in the question earlier from one of the questions, at the beginning of year, what kind of a 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 floor probably seems reasonable from where we’re at. And I think with net-net, the message there’s two messages to I think we’re becoming much more comfortable with our ability to execute in this environment and maybe some easing in the environment itself. And then secondly, I think that it was always our intention. I think we messaged this that these will be short-term metrics that we provide – and I think they’ve served us and our investors well for an extended period of time, but it’s probably time now that we feel that we’ve gotten a better control on it to bring us more – bring us back online, if you will, with what our industry competitors are disclosing and not disclosing.

Keith Jensen:

Yes, we’re not going down to the detail of talking specifically about bookings, as I just mentioned going forward from our backlog, more than what we’ve given to this point.

Operator:

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

Ken Xie:

I think the component and also the cost continue to go up. So that’s where – and also, we still have a pretty tight inventory to make most shipments shipping by air instead of by ocean. So that’s where – so we’ll keep it adjusted by all these costs and probably some of the wet ourselves, some of them we may do some price increase, but we also feel even some price increase, we continue to have a price advantage compared to competitive industry average with our own products. So that’s where the margin we feel probably will be more stabilized. And that’s probably the overall supply probably keep improving.

Rob Owens:

Ken and Keith, thank you.

Shaul Eyal:

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

Shaul Eyal:

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

Keith Jensen:

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

Operator:

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

Ken Xie:

I think we have a few unique advantage. The first from day one, we developed the FortiASIC, which have a huge companion power increase compared to using traditional CPU, but also FortiASIC also working side by side with the CPU. So that’s the huge computing power advantage comes from FortiASIC give us more computing power for the FortiOS to run more function, more security function including a lot of networking function. So that advantage is none of our competitors have that. So that’s making us keeping driving the market share and also the unit shipment, I mentioned, we like 43% of our market shareholder unit shipment there. So that’s what we keeping – give us a long-term growth going forward because also on the convergence of security networking the secure computing power it must have a huge need to address both security and networking function there. Second is for the FortiOS is well integrate together with more function, leverage, security and power. So that’s also kind of a huge advantage for us compared to some other competitor, whether they have to use like a different blade or different functions. They have to go to some different parts or even to the cloud to address some secure computing power there. And then third one, we also have about 30 different products, mostly home developed and integrate, automate together. So that’s also what helping drive we call the wider security fabric on called a mesh network. So that’s also helping the customer to lower the management cost and total cost of ownership. I think all these three factors we’re keeping driving Fortinet better position for the consolidation, both on the product functionality and also on different products into a single vendor platform strategy.

Keith Jensen:

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

Keith Jensen:

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

Keith Jensen:

Thank you.