Fortinet, Inc. (NASDAQ:FTNT) Q3 2023 Earnings Call Transcript

Fortinet, Inc. (NASDAQ:FTNT) Q3 2023 Earnings Call Transcript November 2, 2023

Operator: Good day and thank you for standing by. Welcome to the Fortinet Q3, 2023 Earnings Announcement. [Operator Instructions] Please be advised that today’s conference is being recorded. I would now like to hand the conference over to Peter Salkowski, Senior Vice President of Investor Relations. Please go ahead.

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.

Ken Xie: Thank you, Peter. Good afternoon and thank you to everyone for joining our call. In Q3, we exceeded street expectations in our operation margin and free cash flow. However, building and product revenue fell below our expectation due to a slowdown in secure networking growth, along with challenging in sales execution and marketing efficiency. In response to the slowdown in secure networking market, we are shifting our marketing and sales team’s focus towards a faster-growing secured operation as SASE market over the next few quarters. How while maintaining our consistent focus on leading innovation in secure networking and the convergence of security and networking where we have been a leader for 23 years. While we anticipate limit ear-term growth in secure networking market, it is very important for Fortinet.

As we believe, enable us our platform strategy with a massive footprint in the market leader as the market leader in both firewall revenue and units shipped. The secure networking market is valued at $62 billion [ph] and is projected to increase high single digits annually to $86 billion [ph] by 2027. Our consistent focus on [indiscernible] our industry-leading DOS which supported over 30 network function networking and security application combined with our ASIC-driven performance capability which provides flight to 10x better performance on average than competitors continue to drive our market share gains. Secure networking remain a vital part of our strategy and a market that we believe will return to double-digit annual growth over time.

We have been innovating for some time in the faster-growing segment of secure operations and SASE. Security operations also known as setup is a $46 billion market growing at mid-teens annually to $78 billion by 2027. Fortinet our platform is comprehensive and integrated offering EDR, SIM, SAR, MD and other integrated solutions. Consolidation in the security demand seamless integration and underlying secured tools. Fortinet strength lies in its innovation and its ability to enable automation through a high degree of product integration. Our AI and product and power automatic stock business second, all underpinned by a single consolidated management and analytics platform. In addition to SecOp [ph], we have continued to increase our focus on SASE.

A $17 billion market expected to grow at a 20% compose growth rate to $36 billion by 2027. We believe Fortinet is the only company with a SASE service solution that can perform all functions in the cloud or email and is on with a common operation system. Including 4 networking and security set, market-leading SD-WAN, vWAN and the management council. Our SASE service solution is supported by Google Cloud. With over 100 worldwide SASE cloud location together with our own 30-plus point present and the data centers. For our client-based use case, we are salary SASE service function using our ASIC technology. For instance, we recently announced a Fortinet 1.8G with a security process a side. Which support our full SASE offering which including SD-WAN, firewall, Secure SD-WAN gateway, big lock prevention and boost secure computing region 6 to 54x better than our competition.

We anticipate that success in SASE market will first come from upselling SASE service to our installed base of tens of thousands of AT1 customers. And from attracting new customers looking to leverage a single-vendor integrated SASE service solution. Our industry leadership in both firewall and SD-WAN — the 2 largest components of SASE provides us with a significant competitive advantage. We have a track record of successful execution and believe we are the only company with strong SASE service and the setup solution combined in the same operation system. This differentiation sets us apart and provide us with a significant competitor advantage over peers. While we expect top line growth to be modest for the next few quarters due to challenging networking comparison and our business transformation realignment towards security operation and SASE.

We anticipate growth return to double digits by the second half of 2024. We remain committed to generating healthy operating margin of 25% or greater in 2024 and 2025. Before turning the call over to Keith, I would like to thank our employees, customers, partners and suppliers worldwide for their continued support and hard work. Keith?

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.

Peter Salkowski: Operator — as a reminder, during the Q&A session, we ask you to please limit yourself to one question and one follow-up question to allow others to participate. Operator, you can open the call for questions.

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Q&A Session

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

Hamza Fodderwala: Ken, maybe just for you. To what extent are you seeing SASE start to eat into firewall and network security budgets? Because clearly, there’s a bigger focus there. There is a dedicated go-to-market effort there. So — do you think that SASE is starting to cannibalize the firewall market to some degree?

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.

Operator: Our next question comes from Brian Essex from JPMorgan.

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?

Keith Jensen: Yes. Brian, great question, I should say. One of the slides that we added to the investor presentation for this earnings call actually maps out the what you can see is a cycle — more cyclical nature of the business than maybe we’ve talked about in the past with product revenue. For example, in 2017, I think we had product revenue growth of 5% and that was somewhat of a low watermark. The market may have been due and I think there’s some analyst studies out there from other members of Wall Street that have kind of suggested that the market was due for a little bit of a pause in firewalls. And I think we’re seeing that now. And perhaps there was some delay of that pause because of supply chain issues and so forth, something that may have more naturally occurred in 2021 or in 2022.

I think in terms of confidence, broadly, I think that was the intention of looking at the CAGRs and the success of the company that Canada has led the company through since its IPO and what those CAGRs are. And if you look at that combined with that new slide in the deck, you understand that there’s going to be — there has been the past been volatility in the industry and in the company. But over the longer stretch, you see some very attractive CAGRs in that.

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.

Operator: Our next question comes from Fatima Boolani from Citi.

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?

Keith Jensen: Yes. I think the service provider commentary has probably been reported by a number of other companies through this earnings cycle. I don’t think that’s — the headline itself is not a surprise. I think the significance of the slowdown in the service provider, at least for what we saw in our business was a surprise, particularly because it’s a worldwide service provider number, not just in the U.S. But as I also noted in the prepared comments, we saw weakness in both the U.S. and the Europe, European markets. and that applies to service provider and to the retail sector. I think the retail sector probably is perhaps a little bit more prone to some of the digestion of SD-WAN projects that are still working their way through and maybe that’s a little bit different. As well as some of the economic headlines were probably a little bit disconcerting to the retail sector in the earlier part of the quarter.

Operator: Our next question comes from Tal Liani from BofA.

Tal Liani: Thank you. I have 2 questions on the same topic. If you go back to the last 2 years, you talked a lot about non-appliance sales, meaning upsell SD-WAN which is a head on service and then non-FortiGate. And when things start to slow, we only blame the appliances. So the question is in retrospect, when you look at things and you look at the other parts of the business and you look at the add-on sales and the other features, are they all based on you — the ability of us selling appliances, meaning even if it’s a non-FortiGate, it’s being attached to a FortiGate sale and that’s why it’s going down with it or an SD-WAN, et cetera. So first, just to understand kind of the total exposure of the company from all the successful products that you were able to sell over the last 2 years and now in retrospect, just to understand how is the exposure to appliance?

And the next — the second question which is related to it is if really it’s about applying sales, what is the outlook for 2024 when it comes to do you have any big refresh cycle what could drive outside of easy comps that our comps are getting easier through the year? Is there anything that you’re planning on your end to drive some kind of a replacement or a refresh of the appliances?

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.