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

Fortinet, Inc. (NASDAQ:FTNT) Q4 2023 Earnings Call Transcript February 6, 2024

Fortinet, Inc. isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).

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

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.

Ken Xie: Thank you, Peter, and thank you to everyone for joining our call. In Q4, total billing grow 8.5% to $1.9 billion, driven by increased focus on Secure Op, SASE, and improved execution for our sales team. We closed six eight-figure deals across five industry verticals. All six of these transactions, including all three of our SASE, Secure Ops, and secure networking solutions [Indiscernible] our value of an integrated platform and that span across on-premise and cloud, as well as our FortiASIC technology advantages. Putting a total addressable market across secure op, SASE, and secure networking, expect an increase from $150 billion in 2024 to $208 billion by 2027. Our customer base consists of 76% of Fortune 100, including nine of the top 10 technology companies, nine of the top 10 manufacturers, and nine of the top 10 healthcare.

Our Secure Ops billing grow 44%, accounted for 11% of total billing, with strong performance from several solutions, including EDR, SIEM, email security, and NDR, to automatically detect, investigate, and respond to threats. Unified SASE billing grow 19%, accounted for 21% of total billing. We believe Fortinet is the only company with a Unified SASE solution, all integrated into a single FortiOS, that including a full networking and security stack, consisting of a market-leading SD-WAN, ZTNA, secure web gateway, CASB, and firewall as a service, designed for on-premise and cloud. Our FortiSASE solution is gaining momentum quickly, as we closed our first eight-figure SASE deal for 350,000 seats. In Q4, we added 40 new features to our SASE solution, including support for over 150 PoP location worldwide, and the ability to protect thin edge device.

We see a huge opportunity to attach FortiSASE to our tens of thousands SD-WAN customers. Secure networking accounts for 60% of billing, and represent our largest addressable market. Gartner expects the secure networking market to overtake the traditional networking market by 2030. Fortinet is the number one network security vendor, with over half the global firewall deployment. In addition to physical firewall, we offer virtual, cloud native, and firewall as a service solution, all based on our FortiOS operation system, consolidate over 30 networking and security functions together. Converged security and networking require more specialized computing power than traditional networking. Our FortiASIC power, FortiGate, delivers 3x to 10x more performance as indicated by secure computing region with every new FortiGate product release.

The latest FortiASIC SP5, based on FortiGate 70G, with dual 5G in ruggedized format, secure device within operation technology environment. It is off a great start as a Fortune 50 company signed a eight figure operation technology deal, feature this new FortiGate in the fourth quarter. Also included with our FortiOS operation system is a Forti featured access point controller. Recently, we announced a new secure access point product, making us the first vendor to announce a business grade Wi-Fi 7 product. Fortinet has consistently been an innovative cybersecurity company, and this earning call won’t be complete without a few words about our AI. We have invested heavily in AI across every function and product. For over a decade, Fortinet has used machine learning and AI to provide advanced threat intelligence across more than 40 products from network, endpoint, and application security.

Our solution applies AI and machine learning across expanded digital tech service automatically, containing and remediating incident within seconds, where the industry average for detection and remediation takes several days. We have also been applying Gen AI technology across our entire product line, allowing customers to optimize the security effectiveness and operation efficiency. FortiAI is already available on FortiSIEM and FortiSOAR and more product will be adding this function in the coming months. Before turning the call over to Keith, I would like to thank our employees, customers, partners, and suppliers worldwide for their continuous support and hard work.

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.

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

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Q&A Session

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

Fatima Boolani: Good afternoon. Thank you for taking my questions. Keith, I really appreciate you flushing out some of the factors that are going to be creating volatility in your top-line performance, but what I wanted to focus on was how you are able to hold the line on the expense structure in light of the volatility both on the revenue and billings front. So if you can just help us appreciate how you’re able to manage for profitability, and then by extension, these top-line volatilities, how should we think about the free cash flow cadence against your assumptions on the OPEC structure along with the fact that you have seen lumpy, very large deals that have positively influenced duration for now? Thank you.

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.

Operator: Thank you. Our next question will come from the line of Hamza Fodderwala with Morgan Stanley.

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.

Ken Xie: Long-term, definitely we see that gen AI will increase the traffic a lot and also automate a lot of security operations. We also see the refresh of the firewall cycle. We do provide some kind of a [Indiscernible] data there. But we also see a lot of new opportunity. We now come at the refresh. Like we mentioned in the script, some of the OT technology area and even supporting some work from home and also some other enterprise internal segmentation replacing the traditional switch with a network security firewall that we call the convergence, also starting to get more and more adopted by the big enterprise. So that’s also the new market compared to refreshed traditional firewall. But I agree with you, the next phase connection, the traffic will keep increasing, especially more devices will be connected online and also more people will work remotely.

And at the same time, the AI also kind of generates quite a lot of additional data, which also kind of need to be secured. So we see a pretty good potential for the long-term growth.

Hamza Fodderwala: Thank you.

Ken Xie: Thank you.

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

Brian Essex: Great. Thank you very much. And thank you for taking the question. I guess maybe for Ken, could you dig in a little bit to the SASE performance of the quarter? If I recall correctly, and I don’t know what kind of metrics you can break out to give us a little bit more color behind that. But if I recall, you’re doing quite well with kind of the SD-WAN component. And we’re trying to kind of pivot to better penetrate the secure service edge component. Maybe a little bit of color as you’ve pivoted towards, I guess, focusing a little bit more on SecOps and SASE what is the nature of the deals look like this quarter? What do you see in the pipeline for SASE? And are you getting better traction with secure service edge? And does that include SD-WAN or is it relatively agnostic to SD-WAN? Thank you.

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.

Keith Jensen: Yes, Brian, I would kind of follow that up with some of the results, if you will, of what Ken just talked about. And to your point, I think you’re kind of asking us, if you focus more on the SSE element of SASE and less on SD-WAN, what does that mean. I think that we have a pretty interesting horse race developing internally, if you look at what you would probably think of as the SSE component and the SecOps business, both growing in the 40% range. SecOps won the quarter. We’ll see how SASE does, but they’re very, very close at this point in time in terms of growth. And then I think the other metric we gave, we talked about the pipeline growth, and that 150% would really be around what you would think of as the SSE component.