Fortinet (TICKER: FTNT) Fortinet Inc Ftnt Q1 2023 Earnings Call Transcript

Fortinet, Inc. (NASDAQ:FTNT) Q1 2023 Earnings Conference Call May 4, 2023 4:30 PM ET Company Participants Peter Salkowski - Senior Vice President of Finance and Investor Relations Ken Xie - Founder, Chairman of the Board, and Chief Executive Officer Keith Jensen - Chief Financial Officer Conference Call Participants Brian Essex - JP Morgan Gabriela Borges - Goldman Sachs Fatima Boolani - Citibank Saket Kalia - Barclays Shaul Eyal - TD Cowen Rob Owens - Piper Sandler Adam Borg - Stifel Ittai Kidron - Oppenheimer Angie Song - Morgan Stanley Tal Liani - Bank of America Andrew Nowinski - Wells Fargo Shrenik Kothari - Baird Operator Good day and thank you for standing by. Welcome to the Fortinet's First Quarter 2023 Earnings Announcement 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. [Operator Instructions] Pleased be advised that today's conference is being recorded. I would now like to hand the conference over to Peter Salkowski. Go ahead. Peter Salkowski Thank you, Chris. 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 first quarter of 2023. Speakers on today's call are Ken Xie, Fortinet's Founder, Chairman and CEO; and Keith Jensen, our Chief Financial Officer. This is a live call that will be available for replay via webcast on our Investor Relations website. Ken will begin the call today by providing a high-level perspective on our business. Keith will then review our financial and operating results for the first quarter of 2023 before providing guidance for the second quarter of 2023 and updating the full-year. We'll then open the call for questions. During the Q&A session, we do ask that you please limit yourself to one question and one followup question to allow 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 make today 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 today's call. Lastly, all references to growth are on a year-over-year basis unless noted otherwise. I'll now turn the call over to Ken. Ken Xie Thanks, Peter, and thank you to everyone for joining today's call to review our outstanding first quarter 2023 results. For the first quarter, revenue growth was 32% due to strong growth in both product and service revenue. With 35% product revenue growth, we continue to gain market share while being a leading product revenue company in the cyber security industry. This strong product revenue growth will help drive future service revenue growth. Quarterly service revenue grew over 30% for the first time in six years. We believe we have a significant opportunity to upsell value-added security services to our large installed base. In the first quarter, SD-WAN and OT bookings together continued to account for over 25% of total bookings, and our goal is to become the 1 in Network firewall, Secure SD-WAN, and OT security markets over the next couple of years. Fortinet is leading the trend of network and security convergence and cyber security consolidation. Gartner expects that by the year 2030 the secure networking market will be larger than traditional networking. Traditional networking lacks awareness and control of content, applications, users, devices, and location and is still using the same network protocol that was developed 50 years ago. Fortinet's secure networking solution has expanded from Next Generation Firewalls to SD-WAN, SD-Branch, 5G, internal segmentation, ZTNA and Universal SASE, and we believe, the secure networking market can achieve double-digit growth annually for the foreseeable future. In today's environment, organizations are looking to consolidate their multiple security vendors and functions that are deployed across their expanding attack surface to lower their TCO and management costs while improving visibility and automating real time threat detection and response. Fortinet's latest release of FortiOS 7.4 together with the FortiSP5 ASIC leads the industry with better integration and automation as well as faster acceleration while lowering total cost ownership. FortiOS enables organizations to deploy the Fortinet Security Fabric to every edge, allowing security to dynamically scale and adapt as the network evolves. Last month, we announced Universal SASE, which supports hybrid infrastructure and enables the same networking and security features that are available in our appliances to be delivered as-a-service, all within a single console. Many of our service provider partners are collaborating with us on this offering. Also, we announced enhancements to several of our Fortinet Security Fabric solutions, including endpoint security, cloud security, SoC, and SOAR. As networking and security continue to converge and customers looking to consolidate vendors and point products, we believe we are well positioned to achieve our 2025 billings target of $10 billion while generating an annual non-GAAP operating margin of at least 25% for each of the next three years. 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. Let's start with the key highlights from our strong first quarter performance. Our strong first quarter results reflect a continued demand for our broad portfolio of cybersecurity and networking solutions and the demand for consolidation and convergence that is delivered by our integrated, single platform strategy. Total revenue growth of 32% was led by strong product revenue growth and service revenue growth accelerating to over 30%. Billings increased 30%, our eighth consecutive quarter of at least 30% billings growth. Secure SD-WAN and OT bookings once again accounted for over 25% of total bookings. Our strong top-line results reflect continued customer demand across both Core and Enhanced Platform Technologies, and highlights the diversification of our business model by solutions, geographies, customer segments, and industry verticals. We continued to deliver balanced growth and profitability with better than industry average top-line growth and strong profitability despite the continued economic uncertainty. The first quarter operating margin of 26.5% represents the highest first quarter operating margin in our 14-year history as a publicly traded company. Free cash flow was $647 million, representing a margin of 51%, up 23 percentage points. Both the quarterly free cash flow and free cash flow margin are Fortinet post-IPO records. Last month we hosted nearly 3,000 customers and partners at our very successful Accelerate Conference and I'd like to recap three key themes: one the expanding firewall deployments environment; two, convergence; and three, consolidation. So starting first, today's rapidly evolving threat landscape and connectivity demands a comprehensive approach to firewalls and network security, including a combination of hardware, virtualized software, and security services. In fact, Gartner anticipates that by 2026, more than 60 percent of organizations will have more than one type of firewall deployment, which will prompt adoption of hybrid mesh firewalls. Fortinet is well-positioned to capitalize on this expansion of firewall deployments and form factors as we have been delivering hybrid mesh firewalls for years on a single operating system. Second, the company was founded over 20 years ago on the belief that the convergence of security and networking will become an industry standard. Gartner shares this belief noting they expect the size of the secure networking market to overtake the traditional networking market by 2030. We believe secure networking at scale works most effectively on ASIC technologies. Since its inception Fortinet has been developing proprietary ASIC technologies to build application-specific solutions to support convergence as traditional CPU-based solutions are less efficient at supporting both networking and security. Third, vendor and product functionality consolidation strategies continue to become more commonplace. Looking to Gartner here again, they note 75% of organizations are pursuing a cybersecurity vendor consolidation strategy in 2022, up from 29% in 2020. Our integrated FortiOS platform allows customers to converge networking functionality with security capabilities, while consolidating cybersecurity products and functionality. With FortiASIC's significant computing power advantage, FortiOS can consolidate more security functions and solutions while maintaining our performance and cost advantage. Specifically, FortiOS supports many security applications, including network firewall, SD-WAN, SASE, 5G, WiFi security, ZTNA, VPN, and SSL with a variety of use cases for each security application. For example, firewall use cases include data center, branches, edges, virtual, cloud native, micro-segmentation, both East/West and North/South and firewall-as-a-service. Our convergence and consolidation strategy provides security across our customers' entire digital infrastructure, while lowering their operating costs. Now let's now take a closer look at the first quarter. Billings grew 30% to $1.5 billion, driven by Enhanced Platform Technology solutions. In terms of industry verticals, government and financial services top the list as a percentage of total billings, with financial services up over 40%. Construction, media, and utilities were all up at least 50%. Billings growth benefited from a better-than-expected backlog contribution. While the backlog cancellation rate increased quarter-over-quarter, it was lower than we had forecasted in our model. We continue to believe there is an elevated cancellation risk in future periods for networking equipment backlog. Bookings grew double digits in the quarter, off a challenging comparison of 50% growth in the first quarter of last year. We continue to see success with our strategy to expand further into the large enterprise segment with the number of deals over $1 million increasing 38% to 124 deals and billings on these deals increasing 50%. One of these deals was an 8-figure expansion and upsell opportunity at a Fortune 50 retailer. The retailer was looking to replace their firewall point solutions with a holistic cybersecurity solution. After purchasing FortiManager and FortiAnalyzer in the fourth quarter of last year, this customer selected FortiGate VMs after a very competitive process for their 2,000 store locations as part of our new FortiFlex program. FortiFlex is a new points-based consumption program supporting hybrid mesh firewall deployments as well as a variety of other security solutions. The customer selected Fortinet due to the substantial value offered by our unified platform and their significant technical requirements. In the first quarter, we added approximately 6,100 new logos - reflecting the support of our channel partners through their investments and the investments we've made in them. Average contract term was flat year-over-year at 27 months and down 1 month quarter-over-quarter. Turning now to revenue, total revenue grew 32% to $1.26 billion, driven by strong demand for Core and Enhanced Platform Technologies, increasing 23% and 50%, respectively. Product revenue of $501 million increased 35%, despite the very difficult comparison to last year's first quarter at 54% with its very strong contribution from acquisitions. Product revenue growth was driven by strong growth in Enhanced Platform Technologies, improving supply chain dynamics, and our earlier pricing actions. Service revenue was up over 30% to $762 million, the highest growth rate in services since 2016. The average number of days between when a customer purchases and subsequently activates a security service contract declined slightly sequentially and remained elevated on a year-over-year basis. Service revenue growth was closely aligned with our short-term deferred revenue growth rate in recent periods. Short-term deferred revenue growth was over 30% for the fourth consecutive quarter. Total gross margin of 76.3% was up 190 basis points including a 440 basis point increase in product gross margin to 61.8%. Product gross margins benefited from earlier pricing actions, improved discounting, and easing cost pressures. Service gross margin of 85.9% ticked up 70 basis points as price increases offset increased investments in data centers and Points of Presence, or PoPs. Operating margin of 26.5% was up 450 basis points due to the strong gross margin performance, a foreign exchange benefit, and revenue growth that was 10 points higher than our 22% headcount growth. As previously noted, 26.5% is our highest ever first quarter operating margin as a public company. Looking to the Statement of Cash Flows summarized on Slides 7 and 8, free cash flow was a quarterly Fortinet record at $647 million and benefited from elevated receivables in the fourth quarter of last year and the subsequent cash collections, as well as the record-setting operating margin, and the timing of CapEx projects. Adjusted free cash flow, which excludes the real estate investments, was $662 million, representing a 52% adjusted free cash flow margin and our highest margin since our 2009 IPO. We have come to expect some quarterly variances in our free cash flow results with the first quarter often stronger due to the seasonally stronger fourth quarter billings. Capital expenditures were $30 million, including $15 million of real estate investments. This was lower than expected due to the timing of real estate activities. Cash taxes were $21 million. The Board increased the Company's share repurchase authorization by $1 billion, and the total available share buyback authorization is now approximately $1.5 billion for repurchases through February 2024. Looking forward, we are excited about the growth drivers that we have discussed previously as well as our new single-vendor Universal SASE offering. Our Universal SASE offering delivers a comprehensive solution that extends the convergence of networking and security from the edge to remote users while helping teams drive operational efficiency and reducing complexity and costs by consolidating vendors. In fact, Gartner predicts that by 2025, one-third of new SASE deployments will be based on a single-vendor SASE offering, up from 10% in 2022. As we bring Universal SASE to market, we expect to make various investments including increasing our PoPs. Our guidance reflects the impact of these investments to both our gross margin and capital expenditure estimates. Moving to guidance, I'd like to review our outlook for the second quarter and full year summarized on Slides 10 and 11, which is subject to the disclaimers regarding forward-looking information that Peter provided at the beginning of the call. For the second quarter, we expect billings in the range of $1 billion 560 million to $1 billion 600 million, which at the midpoint represents growth of 21%, revenue in the range of $1 billion 280 million to $1 billion $320 million, which at the midpoint represents growth of 26%. Non-GAAP gross margin of 75.5% to 76.5%, non-GAAP operating margin of 24.5% to 25.5%, non-GAAP earnings per share of $0.33 to $0.35, which assumes a share count of between 790 million and 800 million, capital expenditures of $80 million to $110 million, a non-GAAP tax rate of 17%, cash taxes of $35 million, which is lower than our prior expectation as the deadline for certain tax payments has been extended to the fourth quarter. The second quarter guidance assumes backlog decreases during the quarter. For the full year, we expect billings in the range of $6 billion 750 million to $6 billion 810 million, which at the midpoint represents growth of 21%. This guidance assumes a low-single digit impact on billings growth from backlog. Revenue in the range of $5 billion 425 million to $5 billion 485 million, which at the midpoint represents growth of 23.5%, service revenue in the range of $3 billion $370 million to $3 billion $400 million, which at the midpoint represents growth of 28%. The service revenue guidance implies product revenue growth of 16%. Non-GAAP gross margin of 75% to 76%, non-GAAP operating margin of 25% to 26%, non-GAAP earnings per share of $1.44 to $1.48, which assumes a share count of between 795 and 805 million, Capital expenditures of $400 million to $450 million due to the continued cloud, data center, and facilities investments. Non-GAAP tax rate of 17%, cash taxes of $390 million with approximately $300 million in the fourth quarter. The full year estimates assume backlog returns to historical levels later this year. As we wrap up the prepared remarks, maybe one additional observation. Over many years the Fortinet team and its partners have offered a very solid and consistent level of execution across a wide range of economic cycles and other challenges. Like many others, we see a level of economic uncertainty in front of us and we look forward to this possible challenge in delivering on our goals. 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 followup question to allow others to participate. Chris, please open the call for questions. Question-and-Answer Session Operator Thank you. [Operator Instructions] Our first question comes from Brian Essex from JP Morgan. Your line is open. Brian Essex Hi, good afternoon. Thank you for taking the question and congrats on a nice quarter particularly in a tough macro. Maybe Keith for you, nice acceleration in services revenue this quarter, and I know Ken talked about more effectively selling or selling value added services, secure services into your install base. How much was due to that better attach rate of secure services versus changes in registration policy or pricing increases in the quarter? Keith Jensen Yes, when we, great question Brian and I think when we peeled back the engine looked back that we saw in FortiGuard, which was the security services part of the business and you'll see this in our SEC filings next week, growth was 35% for FortiGuard. So we started looking more deeply at that and to Ken's point, what we saw there were areas like SaaS products and offerings that are attached to existing customers. Certain cloud offerings, what we call Pay-As-You-Go if you will, were attached to it as well. And I would describe those as being a significant driver to the growth. I think the price benefits would probably take the number two slot and then the number three slot would be some changes in the registration behavior. By that I mean, the customer did register a little bit faster in the first quarter, but that lag or that registration policy change that we implemented in the first quarter, I would specifically call out is not really having an impact in the first quarter, nor did we really expect one. So kind of in order, I think it was selling into the install base price increases and then some light improvements in the registration behavior. Ken Xie Yes, also with the new FortiOS 7.4 that started launching, we started to have a more function. We can also enable much more new service going forward for both the current customer installation base and also for new customers. Brian Essex Got it. That's helpful. Maybe as a follow up piece, I think you commented on lower than expected cancellation rate. I know the question will be asked, impact on billings from backlog training and what some of your assumptions are, particularly given what you see in the macro? I know you talked about you expect to be at normalized rates for backlog by the end of the year, but maybe if you could contextualize or quantify that to the extent that you're able to? Keith Jensen Yes, I think in the guidance particularly as we look at the full year, it's kind of difficult to figure out exactly which quarter some of that backlog is going to end up in or be canceled. But for the full year, I think we talked about low single digit growth that would be coming from the backlog. I do think that the risk to cancellations increases as the year progresses, and by that I mean if a customer has only been in backlog for a week or a month or something like that, there seems somewhat less probability that they're going to cancel. But the longer it takes to deliver on that backlog, I think the cancellation risk continues to increase. Ken Xie Also a point is very, you mentioned go back normal end of the year, we see later this year. It could be middle, could be towards the end, but in Q1 I'd say the operation team did a great job to reduce the backlog, which is also helping secure more customer and unload some cancellation rate. Brian Essex Got it. Very helpful. Thank you both very much. Operator Thank you. One moment for the next question. This question comes from the line of Gabriela Borges with Goldman Sachs. Your line is open. Gabriela Borges Good afternoon. Thank you. I have one for Ken or for Keith, it's a followup question on forecasting, which is, we've heard so much noise in the industry around supply chain and COVID catalyst product cycles. How do you all think about true demand and potentially planner and the risk of demand going faster than expected, given you've had a very strong couple of years? Thank you. Ken Xie I think probably some of them will refer to the traditional network security, secure some enterprise, deployment enterprise, but we do see that our solution has a much broader use case and also expand much bigger market opportunities than the traditional enterprise firewall. And also the IT/OT is also see one of our strong growth, continue to helping drive both the new customer and also expanding the current existing customer. Also in the ICE and B [ph] space is a relatively greenfield. We also see pretty healthy faster growth probably even faster than the traditional enterprise, which is more replacement. I think all this I see contributing to pretty healthy, I keep saying double digit growth in the future for the whole security space. Gabriela Borges Yes, that, that makes sense. Thank you. And Ken the followup is for you, which is, as you start to execute more on the convergence of selling into the networking budget or the convergence of networking plus security, when you look at the classic networking competitors, how do you think about the barrier or the limitation for classic networking vendors to get more into security and become more competitive in the convergence over time? Ken Xie I would say from the quality architecture it's very different because security needs much more complete power and to handle the lot of unstructured data, which the traditional networking company, probably more based on some structured data handle, some fixed mix protocol and much less company power needed to process data compared with the network security. So that's where, and also we would have to implement the function and new function come up every year in the software first and then keep enhancing, improving performance leverage ASIC and that's also, we don't see networking company doing some of that. They probably maybe bit slow on where to come up the new function for the security space, all kind of have a different architecture to really supporting the secure computing needed for now security. So that's -- so far, have not seen the traditional networking company really come close. May be they did some acquisition, but so far I don't see they really come up too much since -- to meet a new demand from customer both on the function and also on the service, on the infrastructure change. Gabriela Borges Thanks for the detail. Congrats on the quarter. Ken Xie Thank you. Operator Thank you. One moment for the next question. The next question comes from the line of Fatima Boolani of Citi. Your line is open. Fatima Boolani Thank you. Good afternoon. I appreciate you taking my questions. Ken just a technology vision question for you. You are very, and the team is very bullish on the SASE opportunity that was very apparent at the Accelerate conference as well. But I'm curious as to why you're taking the effort to build out data centers and points of presence to deliver your universal SASE strategy versus maybe some of your peers and competitors who are maybe relying on third party providers and hyperscalers? And then I have a quick follow up, please. Ken Xie Yes. First of all, SASE kind of a vision is little bit different than some of competitors. We do believe need to be universal, need to be more broadly deployed and also more leveraged, a lot of service provider infrastructure. It's kind of a hybrid environment inside of a cloud only SASE solution. And we do keep on expanding some of our path because there's a, definitely, there's some user like whether depend on working from home as a mother or SASE to secure some of their traffic here. But on other side, there's a huge base of customer need to using SASE, our kind of service model, leverage both service provider out their current infrastructure and even onsite appliance. And so that's where in certain point we also see our FortiSwitch and FortiAP are kind of have a agent to helping for the traffic for the Forti [indiscernible] to process all this SASE traffic there. So that's where, that's the reason we kind of put SASE in a single OS, both on the networking side of function like [indiscernible] brand strategy and other plus the security like a CASB DLP, [indiscernible] service, all these things. So that's where we have a more integrated, more broadly distributed and leverage whatever the hyper infrastructure size solution there. That's also the reason we continue to build some other PoP. It's a little bit different than some other leverage certain cloud provider because we do see the cloud provider potentially also can be the service provider to offer SASE and also from the [indiscernible] I point of view even have a little bit more investment from the beginning to build on PoP our self, but long-term will be more profit model, so we have a better margin so that, so we will take some time to make sure we build a healthy ecosystem, both with our partner and also with the investment for long-term benefit. Fatima Boolani I appreciate that detail, Ken. Keith, just quickly for you, kind of a tactical question on the billings outlook. You're raising the full year by less than half of the beat and raised when I think about the first half. And so maybe from a bottom up perspective, can you walk us through what sort of underpinning that conservatism? I can appreciate the macro is jittery, but if you can kind of give us some more tangible considerations you're thinking about in terms of a bottom up perspective on getting to that billing guide for this whole year? Thank you. Keith Jensen Yes. I would say one just kind of as a general thought, I think that raising it to some extent I think probably gives you a little bit of a message that we feel good about our strategy and the execution that level that we can bring to the market. But more specifically and more tactically as we look through the second half of the year, there's probably a little more rigor and effort, if you will, in trying to look at what we see coming in the second half of the year. And I would give you that probably the two headlines that we're looking at. One is we're still very, very pleased with the pipeline. The pipeline continues to be well above anything that we're talking about, growth rates for the company for the full year. But I think the nuance that and maybe it's not even a nuance really that's coming into play now it is more about close rates. It's not just as simple as taking your pipeline and assuming you're going to have close rates that were at the same level they were in prior periods, and that's when we use the term close rates, not a suggestion that deals are getting lost, but this continual cycle that we seem to be in, where some of the larger enterprise deals in particular are taking longer, they're pushing out a lot of pushes. It's not that there's been an increase in losses, but the continual push. And so with that in mind, I think a fair amount of attention of looking at the full year guidance on what we really think our close rates may be for the second half of this year. Fatima Boolani Thank you. Operator Thank you. One moment for the next question. This question comes from the line of Saket Kalia of Barclays. Your line is open. Saket Kalia Okay, great. Hey, good afternoon everyone. Thanks for taking my questions here. Ken, maybe just to start with you, great to see Fortinet sales of the whole breadth of the platform, particularly within the enterprise. Could you just maybe talk about anything that you can do to make it easier for customers to consolidate spending with Fortinet? Whether that's an enterprise license agreement or any other thing that sort of makes it easier to combine, consolidate those vendors, which was a theme I think was talked about earlier? Ken Xie Yes we definitely see some healthy growth of enterprise agreement. And also we're working closely with our channel partner with our service provider also leverage their connection, their resource to build a healthy ecosystem to grow together. But I also see from enterprise level, they also see the benefit of consolidation, definitely. And also not just consolidate some of security product, but also on the expanded infrastructure go beyond the traditional network security. So that's also, we see pretty healthy growth like a cure, and we do see that we could enhanced technology side also has pretty healthy growth. Yes, the sales force also, you can see the number of 1 million deal both on the number and also on the dollar wise has a pretty healthy growth continue to accelerate and grow beyond the total building growths. So that's, that's a pretty healthy trend we see going forward to helping customer consolidate. Keith Jensen Yes. And Saket, maybe just, this is Keith, just to go along a level deeper on what Ken is talking about there, and I'll give you maybe four quick examples. So yes, enterprise agreement is something that we've been doing now for probably a couple years. We track those in some ways as a different line of business in terms of the growth rates and particularly as we've moved into the enterprise, I think it's been very important to be there and we've been very successful with it. I think another illustration of trying to make it easier for customers was the example of the large retailer we gave in the call today. And we talked about the points program, right? Which is an easier way, I think, sometimes for them to, to get on board and consume more of the products. And I think also then when we sell, making sure that we're, our salespeople are well trained on the value proposition that we're offering, not just on the cost of the appliance or the throughput or the performance, but also what it means to the customers management costs and overhead costs as well. And so I think those types of things are all going into play here to support what Ken is talking about, about making it easier for customers to consume more products. Saket Kalia Got it. That's super helpful. Keith, maybe for my followup for you, great to see that 30% growth and acceleration in services revenue. Maybe the question is, how do you think about what portion of your existing subscription base hasn't seen that cumulative impact of the price increases you've done yet. Right? Like clearly the price increases on product have been fully baked, but how much of the base, or maybe how long will it take for the subscription base to fully realize that pricing as well? Keith Jensen Yes, great question and I think it didn't really look at the numbers closely this quarter we did last quarter. A couple things to keep in mind, the average contract term, call it 27 months, if all the contracts are 27 months, you could do that math, if they're not, some are one and some are three year contracts in terms of the renewals that are coming through. So, pardon me, one in five year contracts. Sorry, Peter. Thank you for that. So it does have a long tail and again, I'll refer you back to how many quarters or how a few years that we talked about seeing the uplift that came when we converted to 24 x 7 support from 8 x 5 that was something that continued to provide a benefit for several years. I think the tail gets smaller obviously as you go further out. I think the majority of what's -- of the existing contracts more than 50% are under the new pricing. Saket Kalia Very helpful. Thanks guys. Operator And thank you. One moment for the next question. This next question comes from the line of Shaul Eyal of TD Cowen. Your line is open. Shaul Eyal Thank you. Good afternoon. Congrats on results and guidance in tough macro. Keith maybe starting with you, can you comment, can you provide us with some color about the financial vertical performance this quarter? Keith Jensen Yes, it is well, financial services have always been one of our, I like to say, always been for a long time. They were in the top three and it can be a bit future famine there with some very large deals in the quarter. But I don't think there was anything that was -- it was number two in this particular quarter. Thank you, Peter. I don't think there were any really large deals that drove that number. I think it was, we saw growth and success not only in the U.S., but also internationally, particularly in Europe. And so I think it was a strong quarter for us in that area. Shaul Eyal Got it, got it. From a product mix perspective, so the entry level performed the best versus the high end. Is that just a mix or a macro reflection? And, and also did you have any eight digit wins this quarter? Keith Jensen So we talked about it, yes, we did. Shaul Eyal Okay. Keith Jensen I think we talked about one in the script just a moment ago and I think we commented that was an eight figure deal, if I'm not mistaken, right, without giving a specific number. Yes and I don't recall if there was a second eight figure deal if there was a second. Ken Xie Yes. Also our SMB [ph] had a pretty healthy growth. Like I said, the SMB is a more greenfield for the network security. We do see more and more SMB need and network security to protect their business, especially comes from some other ransomware attack. On enterprise because it's a kind of more replacement and also a lot of enterprise kind of maybe the bigger [indiscernible] how we're more dependent on the service. So that impacts some of the high end. And also the other benefit for some of the low and middle range is really most I would say most IC one and some of the OT deployment are maybe towards the low end, middle range. Shaul Eyal Got it. Thank you. I appreciate it. Well done. Ken Xie Thank you. Operator And thank you. One moment for the next question. This question comes from Rob Owens of Piper Sandler. Your line is open. Rob Owens Thank you very much and good afternoon. Thanks for taking my question. I want to start around OpEx or the correlated operating margin and a very strong first quarter here, I think you mentioned it was the strongest Q1 that you've had since you're public. If I go back through results since you've been public, Q1 has never really been the high watermark from an operating margin standpoint. So walk me through your thought process as the rest of this year plays out was there some aberration in Q1 that really helped drive that or just a lot of conservatism as we look ahead? Keith Jensen Yes, I think that we called out three things and maybe focusing on two; one, we had a very strong gross margin in the quarter and I'll elaborate on that in a moment. And then also FX, continues to provide a tailwind. More commentary about the gross margin, particularly the product gross margin as we move through, the supply chain challenges and then into inflation, et cetera. Over the last couple of years, I think we've talked publicly that our goal was to try and keep the product gross margin around 61% or so. The fourth quarter came in, obviously very low. We did not anticipate that we'd be able to time our price increases and the cost increases perfectly. So they went through the income statement in the same quarter, so to speak. And with that, I think you saw a little bit of pressure in the fourth quarter and then you saw it kind of revert in the first quarter. I think longer-term, we also look at product gross margin as an opportunity sometimes for us to continue to invest in growth. And I think we saw the first quarter gross margin, certainly well above that band that I just talked about. And with that in mind, and as we start to see some of the costs moving out of the equation, and we introduce new products, I think we'll be looking at that in terms of is there an opportunity there to make certain investments in growth while maintaining the margin commitments that we've talked about. Rob Owens Great. And then as a followup, I did want to touch on the OT business and the strength you're seeing there? Can you talk a little bit from a go-to-market standpoint and some of the channel programs, because it does seem like there's some new large channel partners out there that are very excited about the opportunities? Thanks. Keith Jensen Yes, I think OT, we do look at, I mean, you're always trying to organize your sales force around verticals, geographies, or what have you. And I think when we started to see the opportunity in OT several years ago, Patrice and Ken made a decision to start separating that out and having really a separate sales function and some people that specialize in that. I do think that we probably got some first mover advantages by doing that, particularly as we look at Europe and then quickly followed thereafter by the U.S. And yes, there are some large names that are in that space that are providing technology, not security technology, but technologies in the OT space that have been very receptive, if you will, to conversations and opportunities to meet with us. Operator Thank you very much. One moment for our next question. The next question comes from Adam Borg of Stifel. Your line is open. Adam Borg Awesome. Thanks so much for taking the questions. Just for Ken or Keith, obviously it's great to see the strong collections and the record free cash flow. And you also talked about contract terms being consistent year-on-year, and I was just curious though, just given the tougher macro, are you seeing any pushback by customers around willingness to pay upfront? And then I have a follow up. Keith Jensen Yes. Well, first of all, I want to revel in the $600 million of free cash flow, which I've been doing it for some of more quarters, but I'm trying to let people know that a lot of the things fell our way in the quarter. There's always, the conversation in part of the sales cycle, if you will, the customers got a one-year, three-year, five-year deal. And certainly in a rising -- in an environment where interest rates have gone up, I think there's a lot more, many more conversations that exist, around payment terms and things like that. I do believe that, just as we just talked about in the second quarter of 2020 when COVID hit, we have a very strong balance sheet. We obviously have very strong margins, and it's appropriate for us to look at that, to that as opportunities to leverage our balance sheet and sometimes that may be in the form of extended payment terms or what have you, and our income statement in the form of, how we want to go about discounting and supporting growth. So I think that again, the strength that we've had, we have the ability to do those things. If the question is around what are we seeing from some of the enterprise customers, and Ken is seeing a lot of this as well, do we see deals that go from five years to three years? Sure. Is it more than we've seen in the past? I'd kind of look back at the contract term data point that we gave and say maybe, but not a lot kind of a thing. And on payment terms, the channel has always offered a financing function. I think they prefer to provide the financing function and then I think we provide support to the financing function to the channel by making capital available to them through payment terms. Adam Borg That's really helpful. And maybe just as a quick followup, head count was up a little bit over 600 people, quarter-over-quarter up over 21.5% year-on-year. Just curious how we're thinking about headcount growth either in 2Q or later this year, again, just given the macro? Thanks again. Ken Xie Yes, we are, overall we look at both headcount and headcount cost, probably the same pace, company grow the top line, and also try to, at the same time try to improve in some efficiency there. So we're now looking for headcount growth above the top line, even with few, there's a few some question in the area. We also need to do some more investment, on time investment. But companies so far, we feel we have a pretty healthy finance model and this also could be the opportunity to also gain in some market share. Adam Borg Great. Thanks again. Ken Xie Thank you. Operator Thank you. [Operator Instructions] This question comes from Ittai Kidron from Oppenheimer and Company. Your line is open. Ittai Kidron Thanks guys, and nice results. My first question I guess is on the U.S. enterprise, so not U.S. in general, but just the enterprise vertical, clearly one of the most important growth opportunities for you long-term. Can you talk about progress over there, win rates displacements, and is the macro making things easier or more difficult for you specifically in the U.S.? Ken Xie First we continue to invest in the U.S. enterprise. We also see it's a huge growth potential for us because we have relatively small market share and with all the strong product technology we have. On the other side, the big environment definitely slowed down some of the enterprise making certain decisions whether to refresh or something like that. But on the other side our solution has a better lower total cost ownership and also can expand beyond the traditional network security and also helping customers to consolidate. So I think all this combined together, we do see the U.S. enterprise definitely is a strong grow area for us. Ittai Kidron Okay, thanks. And then maybe followup on the competitive side and Ken, maybe you can talk about what have you seen out of your competitors in the U.S. and kind of abnormal activity from discounting or otherwise? Ken Xie I think during the slowdown of some of the big environment, definitely the competitors starting do more aggressive whether on some discount or offer some free for some turn of the free some percentage of free service. But from all angle, we see we have much better product position, much broad like infrastructure coverage and better service, and also both on the performance angle. The product definitely has performed much better for the same function, same cost, and same time. The cost service also has much more value and costs lower than competitors. So for us, we have not experienced like price pressure or discount pressure. It is more about how we can increase the coverage, increase the lease and pipeline, and also to meet the customer need in this big environment change. Keith Jensen Yes, I would think that with, when Ken talks about the figures is fantastic. I think keep in mind, we don't, we have a very, as we kind of talked about prepared market, a very diverse customer base, if you will, between being international, between being very large, mid, small, and MSSPs, et cetera. So I don't want put a policy in place that covers every geography and it covers every customer size. And I think what you're really talking about here is something that for us represents 15% of our business, maybe just a little bit less. And because it's at that size, it's something that we can really more, I think, target our responses to as we get deeper into the selling function as opposed to some broad announcement that we're going to give away services for two years or something like that. Ittai Kidron Very good. Thank you. Operator Thank you. One moment for the next question. This question comes to the line of Angie Song with Morgan Stanley. Your line is open. Angie Song Hi, thank you guys so much for taking my question. I'm on for Hamza Fodderwala of Morgan Stanley. So could you just share a little bit more about your current interest around the SASE or current customer interest around the SASE product and what are some of the responses around this so far? Ken Xie It's a pretty strong growth. And also we're working with a lot of our service providers, both on the infrastructure side or our security service side, and offer the SASE because we do believe SASE should be a ecosystem with a lot of player instead of just a vendor offer their own SASE. Because a lot of I'd say probably most the customer, they prefer some of their data in process controlled themselves whether some privacy SASE or some data sovereignty, keeping the data within certain geo. So that's where we see the SASE approach, we call universal SASE gave the customer flexibility to offer both cloud based on primary space or kind of leverage service providing infrastructure will be more benefit for industry long-term. So that's where -- even sometime we kind of take a little bit more time to develop all the SASE function in the single always. But that's making more easy for the customer, for the service provider to deploy SASE to fit their need at their environment. So we see a very, very healthy pipeline and the strong growth kind of our salary growth. And that's also based on kind of a more healthy margin kind of model instead of do see money, all of our growth. So we want to maintain that model and also working closely with our partner to offer kind of a SASE together to the customer. Angie Song Got it. Thank you. And just one more around profitability. So how are you guys thinking about -- us growth slows down over the next few years, and where do we to see that margin leverage? Keith Jensen Angie, can you repeat that? You cut out in the beginning of that question. Angie Song Yes, no worries. So the question is around profitability, and I was just wondering what you guys are thinking about upside to profitability as growth slows down, and where should we expect to see that margin leverage? Ken Xie We see the midterm model would be $10 billion building by 2025 and with non-GAAP operating margin at least 25% for each year in the next three years. Angie Song Got it. Thank you. Keith Jensen Yes, I think the one thing, Angie, and I think answer about this before as well, keep in mind, two-thirds of the business roughly is service revenue. And that's producing a gross margin that's in the mid-80s. So, and that's, those are longer-term contracts. So I think the business model is such that we'd have time to react if there was something really dramatic that happened in the industry. But part of that's, for that to happen, I think you'd probably have to see some sort of shift in the behavior of the bad actors, the nation states, the organized crime groups, et cetera. And we don't see that's on the landscape. Angie Song Great. Thank you so much. Operator Thank you. [Operator Instructions] This next question comes from the line of Tal Liani of Bank of America. Your line is open. Tal Liani Hey guys. What we've seen with good companies in the last two quarters is that, they make great numbers, but when you look at the composition, new customers are slowing down and sales to existing customers are going up. And we've seen it through multiple companies in the space. So the question is whether you can provide us with some data on sales to existing customers versus new customers, and how is the current environment on customer acquisition, on new customer acquisition? Thanks. Keith Jensen Yes. So as a reminder, Tal good to hear from you again, if you think of the business being, extremely diversified, whether that's geographically or by customer segments, one-third small, one-third mid, one-third large. We specifically called out in the script that we added over 6,000 new logos in the quarter. So obviously and that's probably a growth rate that's, easily into double digits. New logos take a while to really produce revenue for us, it tends to be, less than 10% of total revenue from the new logos. So it creates the opportunity to continue to sell into them. Kind of to Ken's comment a moment ago into your question here, do we see large enterprises in the U.S. still moving forward robustly with all their various digital transformation projects? I think that the, the word on the street is, that slowed down a little bit. And in that environment, I do think that incumbents sometimes have an advantage, but also a cost of performance argument and debate is something that you see customers perhaps more receptive to in the current macro environment Tal Liani And in the current macro environment is the duration of contracts going down or is... Keith Jensen It was flat year-over-year down one month, quarter-over-quarter. Tal Liani Got it. Okay, thanks. Keith Jensen Which somebody reminds me of the room very politely. Every first quarter is down one month. Tal Liani Got it. Sequential. Yes. Operator Thank you. One moment for the next question. This question comes from the line of Andrew Nowinski of Wells Fargo. Your line is open. Andrew Nowinski Okay. Thank you. And congrats on a nice quarter. So I wanted to ask about your SASE offering as well. You talked at the Accelerate Conference about I think having eight to 10 new use cases, driving demand for the firewall, but I'm wondering if SASE could be one of those use cases as well, meaning, is the firewall appliance a critical component of your SASE offering? Ken Xie Yes, SASE definitely is the one the, the use case especially the universal SASE or sometime they called a private SASE for some customer, they some service provider, they want to have a more control of their data. So that's we see is both SASE like the service model, customer benefit service provider has a big value-added that one, but at the same time gave the flexibility of what your full of force some traffic to the cloud or to the pop or have a process on premise and by the appliance. So that's, we see the huge benefit of universal SASE solution, which is very different than some other SASE player and a lot of customers and the partner were interest to at this universal SASE approach. Andrew Nowinski Thanks, Ken. And then maybe a question for Keith just as it relates to your CapEx, you talked about a component of that being used to build out more pops to support the SASE offering, but is that something like, how should we think about CapEx in that investment beyond 2023 as you continue building out your network? Keith Jensen Well, Ken and I are smiling at each other. We've had this conversation that they're I think I've been here for nine years as of this week. One thing I've come to appreciate is that Ken behaves like a long-term investor, and with that in mind owning critical real estate assets tends to have a better payback than leasing them over an extended period of time. Whether that's in R&D facilities, whether that's in manufacturing or warehouse facilities, or that as you, as we move into that, into the SaaS market as well as other cloud offerings it's not just investments in SASE, if you will, but it's also investments in larger data centers in order to deliver various, cloud-based services and solutions. And I think you've heard us talk about that the last several earnings calls and the guys of, data centers having an impact on margins for services and CapEx spending. So I don't think there should be a surprise there, but I think it is a, an indication of our looking to expand into, more fully into some of these other markets. Andrew Nowinski Got it. Thank you. Operator And thank you. One moment for our final question. Our last question comes from the line of Shrenik Kothari from Baird. Your line is open. Shrenik Kothari Yes. Thanks for taking my question. So for Ken or Keith I think Keith, you mentioned about the, the financial services up over 40%, which is surprisingly strong and contrary to what we are hearing from your peers and competitors. So can you expand a bit about upon the underlying drivers? I know you touched upon it but I just wanted to expand on the geographical diversity or is it increased kind of impetus for vendor consolidation that is benefiting you guys in that vertical? So if you can just elaborate and then I have a quick follow up. Keith Jensen Yes, I would say it's all the above. It's happening geographically. I think it's happening with customers that we took down earlier that are expanding with us, with additional firewalls and additional security or additional services as well. I think the market, if you will, financial services, if you step back and look at what's happening there, specifically the firewalls over the last several years, there's probably two legacy vendors there that when they're contracts are up for renewal and we've talked about this for a long period of time, now they're exposed. And it creates an opportunity to come in for a competitive displacement. And I think that some of the other comments or questions today is, is it more difficult in this environment for competitive placements? I mean, sure, you got to work a lot harder to make it happen. You got to make your value proposition more well known. But I think, again I think it's expansion. I think it's opportunity to displace incumbents and I don't think it's specific to any one particular geography. Ken Xie Yes. Also from technology angel, we have a two huge advantage. One is for the internal segmentation of secure data center. So because the ASIC advantage we have, we can deploy in the very high speed environment which a lot of us find service provider, they do need secure their kind of internal segmentation there. The other part, really some of finance service also starting to supporting work from home, working from remotely, which we also have a large super solution with our ASIC based like a small appliance supporting this kind of our broad infrastructure approach combined with that, like SD-WAN or the other 5G, 4G network and security together. So that gave us huge advantage from the product angle. Shrenik Kothari Got it, got it. Thanks a lot, Ken, Keith just a quick follow-up. And you guys, of course, started upon the expansion opportunity in the form factors. Of course, your peers and parties have spoken about unit expansion pressure and how the product unit growth is kind of normalizing. But just wondering, given that give examples of this 8-figure expansion and upsell opportunity replacing kind of firewall with a holistic solution. Can you talk about like expansion drivers broadly like - are you seeing mostly upsell and expansion in form factors versus the units? Just imparted to get some clarification there. Ken Xie Probably both. Yes, we do see the expanding of both the unit and also upsell cross-sell of the entire for the Security Fabric, which has 53 product. So that's where both our internal sales force also partners setting were lot [indiscernible] across for the whole fabric. At the same time, because we combine networking security and more function together multiply case, which also the unit shipment also starting keeping grow quite nicely. Shrenik Kothari Got it. Thanks a lot. Ken, I appreciate it. Ken Xie Yes. Thank you. Operator Thank you. That concludes the Q&A segment. I'll now turn it back over to Peter Salkowski for closing remarks. Peter Salkowski Thank you, Chris. Apologies to the seven people we left in the queue. I'd like to thank everyone for joining today's call. Fortinet will be attending investor conferences hosted by JPMorgan and Bank of America during the second quarter. Fireside chat, webcast links will be posted on the Events and Presentations section of the Fortinet Investor Relations website. If you have any questions, please feel free to contact me. Have a great rest of your day. Thank you. Operator And thank you for your participation in today's conference. This does conclude the program. You may now disconnect.