Fortinet, Inc. (NASDAQ:FTNT) Q4 2022 Earnings Call Transcript

Fortinet, Inc. (NASDAQ:FTNT) Q4 2022 Earnings Call Transcript February 7, 2023

Operator: Thank you for standing by, and welcome to the Fortinet Fourth Quarter Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers’ presentation, there will be a question-and-answer session. As a reminder, today’s call is being recorded. I will now turn the conference to your host, Mr. Peter Salkowski, Senior Vice President of Finance and Investor Relations. Please go ahead.

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.

Ken Xie: Thanks, Peter, and thank you to everyone for joining today’s call to review our outstanding full-year and fourth quarter 2022 results. For the full-year, revenue growth accelerated to 33%. We continue to gain market share in the service security industry with customers increasingly recognizing how Fortinet integrate and a single platform approach to security delivers along total cost of ownership and a greater return on investment than competing solutions. Product revenue growth of 42% was very strong, making Fortinet a leading product revenue company in the cybersecurity industry with total product revenue of $1.8 billion. Our SD-WAN and OT bookings together accounted for over 25% of total bookings. And our goal is to keep growing and achieve #1 market share in network firewall Secure SD-WAN and OT security market over the next couple of years.

For 20 years, Fortinet has made long-term strategies and investments around the convergence of networking and security. Yesterday, we announced our fifth-generation FortiSecurity processor, the FortiSP5. This new SoC base for the ASIC has secure computing power rating for major network security functions like Firewall to support 17x to 32x greater than the average of our competitor similar price model using general purpose CPUs and doubles the ASIC chip acceleration of applications to Forti such as New Trust, SASE, 5G and our SD-Branch with much better performance and efficiency. According to the most recent IDC data on unit shipment of firewall plants, Fortinet hold the #1 unit shipped market share position and 48%, providing Fortinet with an attractive economy of scale position us well as making it difficult for competitors to develop their own ASIC technology due to high entry barrier and significant investment that is required.

Fortinet is a huge security computing power advanced advantages are able for the OS to integrate more security functions and applications than our competitors with much better performance and much lower energy consumption, resulting in a much lower total cost of ownership while offering easier operations for our customers. For example, a recent Forrester report highlighted that customers deploying Fortinet Secure SD-WAN solutions achieved a 300% return on investment over three years with a payback period of only eight months. Fortinet’s substantial installed base of product with reach functions enable us to offer additional secure services, and upsell, integrated and automated for the Fabric Product Solutions. We recently announced several new and advanced services that help SoC team reduce their operations cyber-risk while being more efficient and handling cybersecurity issues.

As networking and security continue to converge and consolidate, we believe we are well positioned to achieve our 2025 building target of $10 billion. 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 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.

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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.

Peter Salkowski: Thank you, Keith. Operator, please open the call for questions. . Open up the call, please. Thank you.

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Q&A Session

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

Brian Essex: Great. Thank you. Good afternoon and thank you for taking the question. And congrats on some solid results and a solid guide. I guess given that we heard from one of your peers last night and they were I guess, markedly more conservative or cautious on the macro than you seem to be. Maybe for Ken and Keith, could you help us understand what you’re seeing in the market from a macro perspective, how enterprises are spending. And how does any changes in the quarter relative to initial expectations pan out with regard to demand, we’re seeing sales cycles. We’re hearing about sales cycles elongating and budget scrutiny ongoing. What are you seeing on your side?

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.

Keith Jensen: Yes. Thanks, Ken. I spot on with that. I would also add, look, I think we’re all sensitive to the overhang from the macro environment and what that may mean is . But when we look at our internal numbers, whether it’s pipeline growth and even if we compare what pipeline growth is today versus a year-ago, it’s even up in terms of percentage growth rates. The use cases, and I think in this environment, the savings that we offer and the ROI that we provide and some of the case studies that we provided in the call there are examples of that. I think we’re continuing to benefit from that, and we do see that continued opportunities for market share gains even in this environment.

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?

Keith Jensen: Yes. I think that the approach that we take, if you will, is consistent this time around with what we’ve done in prior years, but with certainly added conservatism in it to reflect what’s happening or what may happen with the macro environment. And first and foremost, we start with the pipeline and looking at the pipeline growth there and the kind of the timing of the pipeline and making sure that we have deals that are teed up for the middle of the year and perhaps even to the second half of the year. So there’s ample opportunity there. You also want to make sure that you’ve got sales productivity numbers that make sense and sales capacity numbers that make sense. Yes, I think there will be some tailwind from the backlog, which I commented on in the comment that we’re going to get some benefit from that as it continues to burn down.