Fortinet (TICKER: FTNT) Fortinet Inc Ftnt Ceo Ken Xie On Q2 2022 Results Earnings Call Transcript

Fortinet, Inc. (NASDAQ:FTNT) Q2 2022 Results Conference Call August 3, 2022 4:30 PM ET Company Participants Peter Salkowski - VP, IR Ken Xie - Founder, Chairman and CEO Keith Jensen - CFO Conference Call Participants Brian Essex - Goldman Sachs Fatima Boolani - Citibank Adam Borg - Stifel Saket Kalia - Barclays Adam Tindle - Raymond James Michael Turits - KeyBanc Keith Bachman - BMO Shaul Eyal - Cowen Hamza Fodderwala - Morgan Stanley Gray Powell - BTIG John Weidemoyer - William Blair Gregg Moskowitz - Mizuho Andrew Nowinski - Wells Fargo Roger Boyd - UBS Operator Good day, and thank you for standing by. Welcome to the Fortinet Second Quarter Earnings Call. At this time all participants are in a listen-only mode, after the speakers' presentation, there'll be a question-and-answer session. [Operator Instructions] Please be advised that today's conference call is being recorded. I would now like to hand the conference over to your speaker today, Peter Salkowski. Please go ahead. Peter Salkowski Thank you, Hope. Good afternoon, everyone. This is Peter Salkowski, Vice President of Investor Relations at Fortinet. I'm pleased to welcome everyone to our call to discuss Fortinet's financial results for the second 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 operating results for the second quarter before providing guidance for the third quarter, updating the full year. We'll then open the call for questions. During the Q&A, we ask that you please limit yourself to one question and one follow-up question to allow for others to participate. Before we begin, I'd like to remind everyone that on today's call, we will be making forward-looking statements, and these forward-looking statements are subject to risks and uncertainties, which could cause actual results to differ materially from those projected. Please refer to our SEC filings, in particular, the risk factors in our most recent Form 10-K and Form 10-Q for more information. All forward-looking statements reflect our opinions only as of the date of this presentation, and we undertake no obligation and specifically disclaim any obligation to update forward-looking statements. Also, all references to financial metrics that we mine in 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 today for the earnings call will be posted on the quarterly earnings section of our Investor Relations website immediately following today's call. Lastly, all references are on a year-over-year basis, unless noted otherwise. I'll now turn the call over to Ken. Ken Xie Thanks Peter. Thank you to everyone for joining today's call to review our outstanding second quarter 2022 results. Total billings increased 36%; the fifth consecutive quarter of at least 35% year-over-year billings growth. Revenue grew 29% driven by 34% product revenue growth. SD-WAN and OT bookings grew over 60% and 75%, which together accounted for 25% of total second quarter bookings. Our better-than-expected performance demonstrates the strong demand for our cybersecurity innovation. Fortinet is at the forefront of networking and security convergence, enabling our customers to reduce complexity, while securing and connecting hybrid and remote users to advanced security with superior performance. Today we announced the FortiGate 4800F, our latest innovation in converged Network Security. The 4800F is the world's fastest compact firewall for hyperscale data centers and 5G networks. Powered by Fortinet's NP7 SPU, the 4800F delivers Security Compute Ratings of on average 5-10 times better performance than competitive solutions, across the six most common and important functions. A leader in the Gartner Magic Quadrant for WAN Edge Infrastructure, Fortinet continues to take market share for Secure SD-WAN. Our integrated secure SDWAN solution, powered by Fortinet's SPU SOC4, delivers huge performance, security and efficiencies over traditional offerings. In addition to convergence, consolidation of vendors and product functionality is another major trend, particularly in Network Security. In a recent CISO survey, Gartner found the percentage of companies surveyed who want fewer security providers increased to 75% from only 29% in 2020. With over 30 products lines built mostly by our in-house strong engineering and development innovation, Fortinet is benefiting from this consolidation with our Security Fabric MESH offering. The Fortinet Security MESH platform delivers unparalleled protection with broad, integrated and automated protection across multiple edges, from endpoint, to data center, and hybrid cloud environments. These two major trends, convergence and consolidation, position Fortinet well for long-term growth. Before turning the call over to Keith, I'd like to thank our employees, customers, partners and suppliers worldwide for their continued support and hard work, that are contributing to Fortinet's strong growth. Keith Jensen Thank you, Ken, and good afternoon, everyone. Let's start the more detailed quarterly discussion. Second quarter results were solid and broad-based across geographies, customer sizes, industries, and use cases, driving market share gains and demonstrating the strong support from our three key growth drivers: first, an elevated threat environment; second, the convergence of security and networking; and third, the consolidation of security products across our platform offerings. Total revenue of $1.03 billion was up 29%, passing the $1 billion milestone in quarterly revenue for the first time in our history. Total product revenue growth was up 34%. Core Platform and Platform Extension product revenue growth was up 35% and 33%, respectively. We continued to see robust product revenue growth from a wide range of security use cases, including Secure SD-WAN and Operational Technology, or OT. Total service revenue growth increased sequentially to 25%, resulting in service revenue of $629 million. Support and related service revenue was up 26% to $289 million, while security subscriptions service revenue was up 25%, or 2 points sequentially, to $340 million. Service billings, defined as total billings minus product revenue, were up 36%. The year-over-year growth rate for short-term deferred revenue has increased for six quarters in a row from just under 21% in Q4 of 2020 to just over 31% in Q2 of 2022, the highest short-term deferred revenue growth rate in over six years. The accelerating growth rates for service billings and short-term deferred revenue reflect the earlier pricing actions that quickly appeared in product revenue and that are now beginning to appear in service revenue. The pricing benefit more than offset various service revenue headwinds, including suspending services in Russia, an increase in the average number of days between when a customer purchases and subsequently activates a security service contract, and the impact of contract manufacturers delaying deliveries to later in the quarter, which limits our service revenue on new sales recognized in the quarter. With growth and pricing benefits more than offsetting these headwinds, we expect service revenue growth will continue to accelerate through 2022 and into next year. As summarized on slide 6, total revenue in the Americas increased 23%, EMEA revenue increased 28%, and APAC posted revenue growth of 42%. Despite macro conditions that may be more readily impacting other industries, our pipeline growth remains strong. In particular, EMEA's pipeline growth indicates continued strength in our European business. Moving to a summary of our success with large enterprises. Large enterprises continue to favor Fortinet's leading cost for performance advantage and are increasingly more appreciative of our integrated platform. The platform strategy allows customers to converge networking functionality with security capabilities and consolidate multiple point products. Our success with large enterprise customers includes: global 2000 bookings growth of over 65% year-over-year and on a rolling four quarter basis; large enterprise bookings growth of over 55% year-over-year and on a rolling 4 quarter basis; and the number of deals over $1 million increased over 50% to 122 deals and the total billings value of these transactions doubled. Secure SD-WAN bookings grew over 60%, reflecting the convergence of networking and security as well as a strong ROI for our customers. OT bookings were up over 75%, reflecting the continued response to the elevated threat environment. Shifting to billings. Billings of $1.3 billion were up 36%, as Ken pointed, representing the fifth consecutive quarter of billings growth in excess of 30%. I'll pause here to offer thoughts on product refresh cycles and their impact on our financial results. Specifically, we do not believe new product releases drive a near term spike in our top-line growth; rather, we believe the continual nature of our product releases drives long-term growth. For example, each new ASIC is included in a series of products released over several years. Our most recent ASIC chip, the NP7 Security Processing Unit, was introduced in Q1 of 2020. Including the 4800F announced today, we have released 9 high-end Core Platform products with the NP7 chip. Over the next several quarters we will release several additional midrange and high-end products with the NP7. Lastly, I would note that since the start of 2019, we have released over 23 new FortiGate models. While some of our competitors with much shorter product SKU lists may have shown clear signs of product refresh cycles, our strong long-term performance illustrates an extended series of overlapping product maturity curves. Core Platform billings were up 32% and accounted for 69% of total billings. As shown on slide 7, mid-range FortiGates posted very strong billings growth with the mix shifting 5 points in their favor driven by demand as well as supply availability. Platform Extension billings were up 44% and accounted for 31% of total billings, a mix shift of over one 1.5 points. Average contract term was up one month year-over-year at 29 months, driven by the strength from large enterprise customers and the 50% plus increase in the number of deals greater than $1 million. Worldwide government billings grabbed the largest share of the mix at 15% and were up 45%. The top five verticals accounted for 60% of total billings. Moving back to the income statement. Total gross margin of 76.5% exceeded the midpoint of the guidance range by approximately 125 basis points, even as component, labor and freight costs increased, and the year-over-year revenue mix shifted 2 points to product revenue from higher margin service revenue. Product gross margin of 61.9% was up 20 basis points year-over-year and 450 basis points sequentially as pricing actions, product mix, and lower discounting offset higher component and other costs. Service gross margin of 85.9% was down 100 basis points due to increased costs associated with the expansion of our data center footprint as well as labor cost and other costs; partially offset by benefits from FX and some of the earlier pricing actions. Operating margin of 24.8% exceeded the midpoint of the guidance range by approximately 200 basis points. The year-over-year comparison saw the FX benefit offset by lower gross margins, increased travel and marketing costs and other costs. Headcount increased 27% to 11,508. Looking to the statement of cash flows summarized on slides 8 and 9. Free cash flow was $284 million and was impacted by increases in DSO and cash taxes. DSO increased 14 days year-over-year and 5 days sequentially to 80 days due to the change in billing linearity driven by the timing of inventory deliveries from contract manufacturers. New R&D capitalization rules increased second quarter cash taxes by $85 million to $110 million. Second half cash taxes of approximately $135 million are expected to be more evenly spread across the third and fourth quarters. For the first half of the year, our adjusted free cash flow margin, which excludes real estate spending, was 34%. Capital expenditures for the quarter were $39 million, including $21 million for real estate investments. We repurchased approximately 14.4 million shares of our common stock for a cost of $800 million, bringing the total year-to-date shares repurchased to 25.8 million for a total cost of $1.5 billion. The Board increased the share repurchase authorization by $1 billion. The remaining repurchase authorization is now $1.03 billion. Inventory turns of 3.1 times were up a half turn year-over-year and down a half turn sequentially. Moving to bookings and backlog. As a reminder, backlog is excluded from the current quarter billings and revenue. Nonetheless, it is expected to provide increased visibility and a top-line tailwind in future quarters. Bookings were up 42% to $1.4 billion. Total backlog of $350 million is up $72 million sequentially and reflects very strong demand. Of the total backlog, networking equipment accounted for about 50%, while FortiGates accounted for 40%. We believe our backlog is very strong and sticky. Existing customers account for over 95% of total backlog and no single end customer accounts for more than low single digits as a percentage of backlog. There are four deals in backlog, all from previously existing customers, with a remaining balance of over $2 million that together account for 6% of total backlog. Just 4% of ending Q1 backlog was canceled in Q2 and about half of the deals in backlog have been partially fulfilled suggesting that double ordering is not a significant contributor to backlog. Consistent with the first quarter, we shipped approximately 60% of the prior quarter's backlog in the current quarter, as our operation and R&D teams did an excellent job navigating the tough supply chain environment. Nonetheless, we still expect supply chain constraints to be challenging throughout the remainder of the year. We are continuing to address the supply chain challenges in a number of ways, including by increasing inventory purchase commitments, redesigning products, qualifying additional suppliers, and certain pricing actions. We believe that even with these actions, demand will continue to outstrip supply. As a result, we expect backlog to continue to increase in 2022; and while the situation is very dynamic, we believe we will have access to sufficient inventory to meet our guidance. As we balance our pricing actions with the opportunity for continued market share gains, we have passed along most, but not all cost increases. As such, we expect ongoing gross margin volatility from these increases as well as shifts in our product mix related to inventory availability. Before reviewing our guidance, let's offer a few Fortinet specific observations in areas you may have heard discussed elsewhere. In Q2, we noted certain larger transactions with increased or elongated negotiating cycles. Also, linearity pushed to later in the quarter, and later in the last month of the quarter, mainly due to supply constraints and the deliveries. Lastly, close rates were strong and, importantly, the aggregate value of deals that pushed out were within our historical norms. Now, I'd like to review our outlook for the third quarter as summarized on slide 10, which is subject to the disclaimers regarding forward-looking information that Peter provided at the beginning of the call. For the third quarter, we anticipate our solid third quarter pipeline growth across deal types, sizes and geographies to support the following: Bookings in the range of $1,455 million to $1,485 million, which at the midpoint represents bookings growth of 36%; billings in the range of $1,385 million to $1,415 million, which represents growth of 32%; revenue in the range of $1,105 million to $1,135 million, which represents growth of 29%; non-GAAP gross margin of 75% to 76%; non-GAAP operating margin of 25% to 26%; non-GAAP earnings per share of $0.26 to $0.28, which assumes a share count of between 810 million and 820 million; we estimate third quarter capital expenditures to be between $105 million and $115 million; we expect a non-GAAP tax rate of 17%. For the full year, we anticipate backlog that could approach or possibly exceed $500 million that will be offset by robust industry growth, pipeline strength, and market share gains fueling our growth and support the following: Billings in the range of $5,560 million to $5,640 million, which at the midpoint represents growth of 34%; revenue in the range of $4,350 million to $4,400 million, which represents growth of 31%; total service revenue in the range of $2,620 million to $2,670 million, which represents growth of 27% and implies full-year product revenue growth of 38%; we expect non-GAAP gross margin of 75% to 76%; non-GAAP operating margin of 25% to 26%; non-GAAP earnings per share of $1.01 to $1.06, which assumes a share count of between 810 million and 820 million; we estimate full year capital expenditures to be between $300 million and $330 million; we expect our non-GAAP tax rate to be 17%; we expect cash taxes for the year to be $265 million, as I mentioned earlier, cash taxes paid are higher in 2022 due to the new R&D capitalization rules in the U.S. Along with Ken, I would like to thank our partners, customers, suppliers, and all members of the Fortinet team for all of their hard work, execution and success. I'll now hand the call back over to Peter to begin the Q&A session. Peter Salkowski Thank you, Keith. 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. With that, Hope, please open the call for questions. Question-and-Answer Session Operator Thank you. [Operator Instructions] Our first question comes from the line of Brian Essex with GS. Brian Essex Great. Thank you. Good afternoon and thank you for taking the questions. Congrats to team on a nice set of results for the quarter. I was wondering if maybe -- and Keith, I certainly appreciate the commentary and the granularity with the full year revenue guide. Can we maybe unpack some of the commentary on the services side and the lower, I guess, services revenue guide for the year? Maybe help us understand what's going on there. And maybe pair that with your comments on delays in activations and how much insight you might have there that gets folks comfortable that there isn't pull-forward? Thank you. Keith Jensen Yes. I don't think -- Brian, I don't think pull forward really applies to the service revenue line, but maybe -- it's actually a couple of questions at once. I think the answer to your question about service revenue, I think the biggest change from where we started the year is really about Russia. If you think about Russia, we talked at the very beginning, it's about 1.5% of our total revenue. And it applies to the service revenue line as well. Earlier in the year, we stopped recognizing revenue on existing contracts for services that provide in Russia in conjunction with our suspending of services. At that time, we did not anticipate it would be a full year event, but we are now. And if you kind of think through that 1.5% of service revenues in Russia, so we really backed out now for the full year about $25 million of revenue related to Russia. That's the largest change there. I think the delay in registrations from when contracts are sold, when they're actually registered by customers, I think we pretty much got out of the quarter what we expected on that. That seems to be something in the current environment with inventory constraints that we're going to continue to see. I think the linearity part of it is a little bit new in that because the shipments occurred later in the quarter, there really wasn't the opportunity to get the service revenue from those Q2 shipments that we would normally get. And so, I think those are really the parts to put together there. On the other side, I would probably point to, again, the short-term deferred revenue billings and the number that we're putting up here and the growth that you're seeing with that number as well as service billings itself. And I think the last comment on this, and we haven't talked about it before, is that the service contracts are really a use it or lose it contract, meaning it's not that they have the ability to cancel, they just have the ability to postpone the registration for a period of time, whether -- depending upon the geography, whether that's 90 days or one year or what have you. So, eventually, it comes to revenue, but the timing has been pushed out to that aspect. Operator Our next question comes from Fatima Boolani with Citibank. Fatima Boolani Hey. Keith, this one's for you. Just with respect to some of the backlog detail and commentary that you shared, I want to hone in on the cancellation rates that you quantified for us. I believe you said it was about 4%. Can you give us a sense of what are some of the reasons behind the cancellation? And what gives you confidence that that 4% isn't going to stretch or escalate into maybe mid to high single digits? Thank you. Keith Jensen Yes. I think I would point to some of the factors that we've talked about before. I think that last quarter, we talked about the cancellation rate being 5%, I think we're seeing it now 4%. I think it's unlikely that existing customers, particularly those that have received partial shipments are going to cancel. Also, I don't want to