Fortinet (TICKER: FTNT) Fortinet Inc Ftnt Presents Barclays Global Technology Conference Transcript

Start Time: 15:45 January 1, 0000 4:15 PM ET Fortinet, Inc. (NASDAQ:FTNT) Barclays Global Technology Conference December 06, 2023, 15:45 PM ET Company Participants Michael Xie - Founder and Chief Technology Officer Peter Salkowski - SVP of Finance and IR Conference Call Participants Saket Kalia - Barclays Operator Saket Kalia Good afternoon, everyone. Welcome to day one of the Barclays Tech Conference. My name is Saket Kalia. I cover software here at Barclays. I'm honored to have the team with us here from Fortinet. We've got Michael Xie, Founder and Chief Technology Officer at Fortinet. We also have Peter Salkowski, SVP of Finance and Investor Relations. Just to frame this, we've got about 30 minutes together. Let's take the first 20 or 25 minutes to do some fireside chat with Michael and Peter, which I know is going to be fun and really educational. And then we'd love to make this interactive. If you have any questions, pop up your hand for Michael and I'll get him back. We'd love to take any questions from the audience. And maybe with all of that as a framework, Michael, Peter, thank you so much. Peter, over to you. Peter Salkowski One real quick request, the safe harbor statement, if you can throw that up on the screen, that would be great. I'd like to remind everyone that we may make forward-looking statements during today's fireside chat. You can read that there if you can. But these forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those projected in these statements [indiscernible] Risk Factors in our most recent Form 10-K and in other reports that we file with the SEC for additional information on factors that may cause actual results to differ materially from those of our current expectations. All forward-looking statements reflect our opinions only as of the date of this presentation and we take no obligation and specifically disclaim any obligation to update forward-looking statements. Thank you. Saket Kalia Michael, maybe let's start with you. First of all, thanks so much for being with us here today. Really appreciate you taking the time. So Fortinet announced a new segment breakdown on your last earnings call. As you were sort of thinking about the business now, I think in three areas, right? So there's secure networking, secure operations and I think universal staffing. Those are kind of the three new segments. And I'd love to dive into those segments a little bit later from a product perspective, but I want to start a little bit more broadly. Maybe you can just talk about why Fortinet decided to make this strategy change now. You and Ken have been through the ups and downs of hardware cycles before. Why is now the right time to maybe accelerate your business, shift to SASE and secure operations? Does that make sense? Michael Xie Yes. Well, thanks for having me. And so I think from the longer period of time, we see that SASE is just natural evolution of the cyber security strategy. We have been working in this area. We made acquisitions actually a couple of years -- since a couple of years ago. And so we obviously need to build foundations. And the way that we see it is we're not really shifting away from our firewall business. We see that SASE is more like a natural addition of that business. And underneath the technology is the same for the OS. Rather than running on a prem, the SASE allows us to run it in the cloud. I think there are a couple of drivers for us to call it out and make everyone focus. One is in order for somebody to offer effective SASE, we need to build up a global presence, or in the terminology we call it PoPs, the point of presence. We've been doing that for almost two years. We have about 30 or so PoPs that we built. But I think a lot of competitors always suppose they have 100 PoPs, 200 PoPs. And we announced a partnership with Google, which they allow us to use their global premium networking, which adds about 180 PoPs to our SASE offerings almost instantly. So I think one of the reasons we were able to really start to strengthen our methodology for SASE was because that global extension of PoPs. Saket Kalia Yes, absolutely makes sense. Peter, maybe just to level set us from a financial perspective, we all saw the numbers. But I think it's important for us to just sort of have a good understanding of the path that you've sort of articulated from here. Can you just maybe remind us of some of the expectations that you laid out for fiscal '24 in your last earnings call? Peter Salkowski Yes, we're not guided into '24 yet. So obviously, just some sort of indications of where we think, because people were concerned about what the future looks like always. I think from a billings perspective, what we said for 2024 was that we would expect the billings growth to return to double digits by the back half of next year. I think what's important in that is that's a change in the guidance than we had given in the second quarter earnings call. In the second quarter earnings call, we had said that billings growth could return to double, mid to high teens by the fourth quarter. Obviously, we've pulled it back a little bit with how the third quarter prepared or worked out and things like that. I think the question I get a lot following that up is, well, what gives you comfort to getting to double digits by the back half of next year? First of all, we won't be on a -- we'll be on an apples-to-apples comparison basis by the time we get to the fourth quarter. So what I mean by that is we won't have the backlog contributions that we had in the first half or first three quarters of 2023 to compare against when we get to the fourth quarter. It'll be apples-to-apples in terms of that comparison. I think also, we'll be further along in the SASE SecOps journey, which I think will benefit us by the time we get to the back half of next year, a little bit at least. And then I think just the conditions of the market, I think, will be better. I think right now we're kind of going through a weaker macro, bit of concerns there with regards to interest rates and all that kind of stuff. Although, apparently a couple of weeks ago, interest rates are off the table. Everything is fine again. So I think that's kind of what we've got it to. I think the street -- I still have some analysts that are at much higher billings growths in the back half of the year. Last year, they didn't listen to the last earnings call. They're still stuck on the prior guidance that we gave. And I think the street does need to look at service revenue a little bit. We've seen a deceleration in the business this year. Service revenue is a backward looking number. Saket Kalia That's right. Peter Salkowski And so you need to look at service billings which is more forward-looking and deferred revenue. And the change in short-term deferred and look at your revenue there in terms of what that might translate. Saket Kalia Got it. Super helpful, Peter. And I want to dig into some of those things later on. But Michael, I want to come back to you. And I'd love to dig into some of the three segments just a bit deeper. And I wanted to start with secure networking, right? Which really makes up the largest portion of business. I think it's 60% or 70%, you've said 70%, right? Can we just walk through, again, you and Ken have been through multiple hardware cycles before. Can we just talk through some of the dynamics that are leading to that slower growth for firewall appliances right now? And again, because you've been through so many cycles in the past, how do you sort of compare this cycle to some of the prior cycles that you've seen? Does that make sense? Michael Xie Yes, it makes perfect sense. So I think there's obviously cycles for any business and particularly in our hardware business. It's been sort of every few years it's accelerated and then slower, accelerated again and slower. This recent cycle is a little bit special because of the COVID and the supply chain issues. I think it's last year, there was a time where, as long as you can ship the customer would buy no matter what and then -- so, but now they would put an order and want to wait for a long period of time and then when it's available, we can ship. So we have hundreds of millions of backlog. I forgot the number, but Peter should have this, basically power up for a few quarters. Like now, obviously we're coming down to the end of that. So essentially that backlog would be close to like very minimal to the normal level. So essentially the growth because that backlog -- filling the backlog that number will be added to our normal growth number, so making that cycle like much steeper and bigger than what it used to be. Saket Kalia Right. Michael Xie So, I think that's one way. And I think the other thing is these cycles also have to do with, number one is macro economy, interest rates and what have you, basically customer spending habits. And also, how the technology evolves and then the customer would be basically, when they're looking at different offerings, they would say, should I wait until something better appears or I need to buy something now. So these factors combined basically generate new cycles for our industry. Saket Kalia Yes, absolutely. Peter Salkowski Something to add to that. I think we're a victim of our own success. I think is one way to look at it. I know people want to look at the future and say, they got an implied 9% product revenue growth for 2023, but they have to remember we had 40% -- 42% product revenue growth in 2022. So if you look at the overall health of the company, I'll take that 42%, right? Because that means I got it and I'm growing and I'm continuing to grow off of that. So, to Michael's point, there was a couple of years of abnormal growth that probably occurred because of supply chain and our ability to really manage our own inventory, which I think benefited us. If you go back to 2021, and it's kind of when the supply chain started to hit, industries and people started talking about supply chain, Fortinet was probably six months to nine months lagged in terms of that impact because we had inventory and we were managing our own inventory. And so that benefited us, great for us, but we are going to have to cycle through that. Now, what's important though, is product revenue growth started to slow at fourth quarter to first quarter of last year. You don't see it as much in the fourth quarter of last year and the first quarter of this year because of backlog coming down and contributing to product revenue growth. But we're already three quarters or four quarters. My point is, we're already three quarters or four quarters into the cycle in terms of that deceleration. And if you look at prior cycles, it was 2009, 2013 and 2017 were the bottoms. And it was up to down to, up to down to, up to down to. So don't know where this one's going to be, up two years, down two years? Up two years and down two years. Saket Kalia Up two years and down two years? Okay, got it. Peter Salkowski Sorry, two years up, two years down, right? `09 to `11, `11 to `13. Saket Kalia So arguably, we're almost halfway through, right? Depending on how long the cycle is. Peter Salkowski And the question is going to be how much of the backlog contribution in this whole supply chain thing, does that skew the thing or do we return in a sort of normal cycle? Michael Xie Also, I think I would add, typically in these cycles, when the business are growing at 30%, 40% year-over-year, you tend to basically keep the current process as long as it works and hire anybody that who looks like competent. And then when you grow to a certain extent, you will see that, okay, actually some of the business processes, they don't scale up to this level. You need to actually take it apart and put in some new mechanism, make it more efficient than the people that you hired. May not 100% of them are all the people that you actually want and you actually digest this growth and then basically get some better people to get more consolidated business people and processes. So I think we sort of over the past couple of decades is being going through these cycles, expand and then digest, expand and digest and map up two and down two, that was the cycle. Saket Kalia Yes, absolutely. Peter, maybe just to put a bow on sort of the firewall question, right? Like once we sort of pass this period of difficult compares to what I'll just air quote a normal environment, what do you think the market growth rate in firewall will sort of settle into over the next few years? And how do you think Fortinet's growth rate will compare to that? Peter Salkowski First of all, I'm looking forward to a normal environment when it is again. God, I hope there's no more Black Swan events in the next three years. Yeah, I think if you look at our network security business, and the TAMs that we provided on the earnings call and the growth rates that we provided of that, we think it's a high single digit growth business for the industry. We think for Fortinet, we can return to double digit growth. I mean, Ken will talk 10% to 20%. I don't know where we fall in that range at this point. But if you look at the 14 years that we've been a publicly traded company, one of the slides that we concluded in the earnings deck was to show that over that 14 years, our product revenue growth and our service revenue growth have catered out to be 24% a year for the last 14 years. And so -- Saket Kalia Largely organic, right? Peter Salkowski Exactly, largely organic, there's not a lot of acquisitions in there. And only recently have there been price increases. And so I think we feel comfortable. There's also a part of that, you know, we've talked about this more recently, a part of that cycle or part of that growth of the network security business is we think we have a differentiated and superior product from an ASIC perspective, certainly from the hardware. It's really the operating system. We can get into that in a minute, but we can't take market share from companies who aren't replacing their own products, right? For us to go in and replace one of our competitors' firewalls, the customer has to be wanting to take that out in the first place, right? Saket Kalia Right. Peter Salkowski And we're in a cycle right now where people are saying, I'm going to swap my assets. I got high interest rates, interest rates have increased up. We're back to 2009 in terms of interest rates and we got there in less than a year. People are, I think, a little bit of shell-shocked on that. So when we get back to that sort of happening again, and we do believe it's going to happen, then you have an opportunity to grow faster than the market because you can start taking market share -- Saket Kalia It's more flex there. Peter Salkowski But you also have to realize, I mean, we've doubled our product revenue growth, it's probably doubled in the last three years. We're the largest company in the network security space in terms of product than any other players and it makes sense because we also have a very unique and differentiated solution. Saket Kalia Absolutely. Michael, I want to shift gears and maybe talk about your SASE solution. And we touched on this earlier in your earlier response, but I want to talk a little bit about sort of the Network's PoP coverage, right? Because I know it's important for your customers. So maybe you can just recap again sort of your strategy around coverage with points of presence, right or PoPs, and how you're working with service providers sort of building your own PoPs and sort of data centers? Does that sort of make sense? How do you think about the coverage model overall? Michael Xie Absolutely. Yes. So we have basically three basic strategies of coverage. Number one is, you know, we have started building and we'll continue to build our own backbone. So before the Google deal was announced, we had about like 30 and then we have about I think 35-ish PoPs in operation now, and that will continue to expand. So these PoPs, number one is, allow us to basically run things at lower cost because we own a lot of infrastructure and equipment. Number two is that, we can basically build these on the different strategic locations. We can choose which location that makes sense for us that have the best return. And number three is that we can actually run our ASIC-based hardware which further give us a cost advantage in performance. The second strategy on the presence is, we collaborate with these large hyperscalers like Google. Yeah, maybe there will be more coming down the road, which essentially is they build these premium networking locations that are offered as our PoPs. So we run the 40 OS, usually in like a VM, the virtualized or like container software in these PoPs. Now, the benefit is like they usually have very good global coverage. Their backend is very solid. The one disadvantage usually is the cost because we cannot run our hardware in those PoPs. Like it has to rely on their entire stack in the virtual machines, the same public cloud limitations. But I think they will be a big part of a strategy because of their presence, even if it's at a somewhat higher cost. And the third strategy for us is basically we do -- we have a really good relation with a lot of the carriers, service providers internationally. So we offer a co-build functionality to allow these carriers to run SASE on their own networks using our technology. So it wouldn't be like our PoPs anymore, it would be their PoPs. But our technology enabled them to, you know, who owns those data centers to be a SASE provider. Saket Kalia Right. Interesting. Peter, maybe just on that point, can you just remind me what we said about the size of Fortinet SASE business currently and sort of how you thought about the estimated market growth rate and actually, let's just start there? Peter Salkowski Yes, sure. I think SASE, by defining what we talked about in third quarter earnings calls about 20% of our business. I think what's important in that number is, if you look at what's listed underneath SASE, the first thing listed is probably SD-WAN, right? And up until really this point, although we've been talking about SASE most of this year, up until building out our own points of presence along that process, up until this third quarter, we were talking about SD-WAN as a percentage of billings or we started combining it with OT and saying SD-WAN and OT combined were 25% of billings. The last time we gave a number for SD-WAN was probably a year, maybe 18 months ago and it was 15% of our billings at that point. So when you look at that 20, most of that 20 is SD-WAN, right? And that's just being honest about, what we were selling over the last several years in terms of our growth in SD-WAN. We have a SKU called FortiSASE that we're selling that combines or puts together all of the SASE solutions, the SSC side of it or the services side of it, but that's a small part of the business today. We've done some things this year that got us to a point where talking about SASE made more sense. And Michael talked about the Google Cloud relationship. I would say that the Gartner Magic Quadrant for single vendor SASE that came out in August, putting Fortinet as a challenger in that Magic Quadrant for a company that hasn't talked about SASE for the last five years to have the position that we have in that Magic Quadrant and be one of only eight companies that are qualified as a single vendor SASE company says something about our solution and our ability on a going forward basis. And so -- and also coming out with our SP5 chip earlier this year, starting to build it into our firewall capabilities, because that chip has 14 functions that are built into it that can speed the process up. The prior chip, the SOC4, only had seven functions. Some of those functions that are in that SP5 chip are SASE related, SD-WAN built into the chip, some of the zero trust capabilities built into the chip level. So we can accelerate the capabilities. I think what's really important on the SASE side is, we talk about it as universal SASE and I think that differentiation relative to our competitors is very important. Depending on the customer and their need or want, we can do SASE in the SASE capabilities in their data center. We don't have to take it off-premise. Taking it off-premise and really putting it in the cloud is really borrowing the cloud structure's compute power because the company doesn't have the compute power on-premise, that's not Fortinet's problem. We have the compute power on-premise, if you want to keep it on-premise, we can do it on-premise. If you want to do it in the cloud, yeah, we can do it in the cloud. We just need to build out some infrastructure to be able to have our own infrastructure. But we can give you that same operating system on-prem and in the cloud wherever you need it. So if you look at our latest marketing brochure, it comes back to the terminology of Fortinet everywhere. And we've been talking about being at all edges for a long time. It's really just moving that compute power to the cloud if that's where they want it. We can do it in the data center. So I think to answer your question, Fortinet SASE today is a very small part of our business. Keith talked on the earnings call about having a couple of hundred SASE customers today with no marketing behind it, with no Google Cloud relationship, without the Gartner Magic Quadrant, we had adventurous or entrepreneurial salespeople who went out and sold FortiSASE. We have tens of thousands of SD-WAN customers that we can upsell to SASE and that'll be our initial focus on it going forward. Saket Kalia Yes, absolutely. Maybe just to bring some of this stuff home and maybe it's a question that both of you can tag team. But as we've sort of rethought the segmentation of the business, how do go-to-market strategy changes kind of you don't play into this as well? And maybe as part of that, obviously, Patrice, right, very longstanding Chief Revenue Officer, I think announcing it as he retire, maybe we could touch on that as well? Michael Xie I can maybe provide some comments on the technology side. Go-to-market for SASE which is basically cloud-offered operated security versus the primarily on-prem or VM-based firewall for FortiOS, there definitely is some differences. The sales force is between how to basically sell these, present these to POCs and basically answer RFPs. Now, however, if you look at us versus some of the major competitors, our SASE is built upon the same Fortinet OS that we've been selling for 20 years. A lot of salespeople are super familiar with that. So it's actually a smaller challenge for us than for a lot of the other companies. And we're in that journey. I think the last number I saw was 97 of the sales people have been trained and certified on SASE. So it's a relatively quick process for us. But obviously, growing from a small number to a big number is going to take time. So I think we're in that process. Peter Salkowski To clarify, 97% of the salespeople, not 97 people. Saket Kalia 97%, yes. Peter Salkowski 97% of the sales people have been trained at that. Saket Kalia That's quick, huh. 97%? Wow. Peter Salkowski Well, we've been doing it for a while. On the Patrice, one -- Patrice has been with the company almost 20 years, came in, used to be a distributor, owned his own company as a reseller. And so was a Fortinet reseller and then they came, grew through the company in terms of he used to run in French. I think it was in 2015, he became head of sales, global sales. I think if you go back to 2015, we were $740 million in revenue. I think our guidance for this quarter, the midpoint is $5.3 billion. So I think he's done just fine for us. Ken will say that he's been trying to talk Patrice out of retiring for several years now. You kind of knew it was getting closer when Patrice started working on his golf game. So this isn't really that big of a surprise. And it's something that he told us, we've announced it, but we're not looking until probably sometime in next year. I think the 8K - we have said middle of 2024. Saket Kalia Yes. Peter Salkowski The follow-up question, which is a fair question, is what are we going to do about it? Patrice is going to certainly work with us. We have a fairly large, very strong bench of people who have been with the company for a long time in sales. I think Patrice was based in Europe, and our European sales force is very strong and does a great job. Not that our U.S. sales force isn't doing a great job, but I think we'll look at a model that we've had before where you have a head of sales in the U.S. or America, Canada, U.S., Latin America, and then a head of sales running Asia-Pac and EMEA, to give it more that -- not just to give it more close in terms of where the sales people are, but they're different markets. We're the number one. If we're not number one, we're number two in most European countries. And we're 70% of our revenue is outside of the United States. When you start looking at that, it's a different sales motion in a lot of the EMEA countries. We go through our channel. They work very well with us. We're very well-versed in doing that, whereas in the US, it's a much more direct sales kind of motion. You've got to build those. Even if it's through the channel, you've still got to build those relationships. Ken's not here because he's in the Midwest right now meeting with a customer, right. Keith's not here because he's at the same meeting. You have to have that relationship and build those relationships. It's a different sort of way of doing it. And I think having someone geographically closer to those, I think, will be what we'll look at. Saket Kalia That makes sense. That makes a lot of sense. We've got about five minutes left before I maybe shift to some margin questions. Any questions here from the audience? Peter Salkowski Thank God, margin questions. Saket Kalia We'll get right into it then from a margin perspective. And again, maybe a question that both of you can tag team, but just maybe on margins more broadly. Ken and Keith, I think, reiterated sort of their 25%-plus margin target for fiscal `24 on the last call. But Fortinet's been sustaining I mean 26%, 27% margins here over the last few years. And you guys correct me there if I'm wrong. So maybe the question is, how is the team sort of thinking about this balance of growth and profitability now that we're starting to see growth maybe a little bit more normal? Michael Xie I think as a company, Fortinet's been always very disciplined in the spending. We don't have huge acquisitions. And we always look at the valuation of the acquisition very carefully. And so I think in the past, I think one of the challenges is forecasting the margin. Because when you do that and when the sales knock it out of the park and they're consistently doing that, then you get a better margin. Because we don't want to spend it in the last day of the quarter just to make the margin lower. So now, I'd say moving forward, if the forecast is accurate, which we think it will be, then I think we'll be able to manage the margin and hit a target. And if they can deliver that, they can hit again out of the park again quarter-after-quarter. And then I think we're probably going to see a higher margin in the future too. Peter Salkowski I think the other side of that is Ken has always been wanting to grow the business, right. And you've seen it a few times in the history of Fortinet, the one to go back to is kind of probably 2013, 2014, 2015 time range. Very strong growth, but the margins went from 25% to 12%. Since 2017 was the first time that they had a 25% target, which back then the margins were in the mid-teens, they said 25% by 2022. I've been here since 2018. We've said 25% for the last five years, almost six years now that I've been here. Yeah, we reached 25% early, before even 2022. I think because of COVID, we actually got there in 2021. And we've kept that as a floor now as sort of the margin. We're just basically telling people, look, we can grow the business. We'll guarantee a floor of 25% on an annual basis. I don't want a quarterly basis, because first quarters can always be wacky. But on an annual basis, we can keep that as a floor. But we want the flexibility to grow the business and be able to invest in sales and marketing and R&D to grow the business on a going forward basis. So that's where Ken gets comfortable saying, I'm going to give you 25%. If you go back to 2022, margin benefit is a couple 100 basis points just from FX, because we price everything in dollars. Dollar was really strong. We pay 70% of our people in local currencies, because they're outside of the United States. So you get a couple 100 basis points of benefit from that. So we did 27% that year. If you look at this year, I think our guidance is around 27%, again, somewhere in that range. For the full year, you're seeing the benefit of the model. In last year, when product growth was growing 42%, services revenue declined from 65% of my revenue a couple of years ago to about 60% of my revenue. Well, now with services growing faster than product, I'm going back to more services. I'm getting the benefit of an 85% gross margin on services that's dropping to my operating margin line. So depending on how that plays out in the future, there's a little bit of variability that's going to be there. I don't know what the dollar is going to do next year. I had heard it was going to get weaker, but now I'm not sure, because interest rates are coming down next year. I don't know what the hell is going on. So we'll see. But the point is, we're guided to at least managing at 25%. I'm in charge of building the model for next year right now. I will tell you that we're above 25% in terms of the internal look. But now the question is, going back to Ken and Michael and others, what do you need to spend on? What do we need to focus on? What are spending categories? And how -- where do we stay within that 25%? Saket Kalia Got it. Well, guys, we've got about 30 seconds left. Maybe just the last question, open-ended. I ask you this on call backs, is there anything that we didn't ask that we should have? Is there any last message that you want to get across as we leave these folks and wrap-up the session here? Michael Xie I think just that Fortinet is continuing to be an innovation-driven company. And we have a lot of strength in technology and we'll continue to invest. And I think we feel confident about the technology in a lot of markets. I think long-term outlook for us looks good. Question-and-Answer Session Saket Kalia Good thing, we've got a way to end it. Michael, Peter, thank you so much for the time. Appreciate it.