Fortinet, Inc. (NASDAQ:FTNT) Q2 2023 Earnings Call Transcript

Fortinet, Inc. (NASDAQ:FTNT) Q2 2023 Earnings Call Transcript August 3, 2023

Fortinet, Inc. beats earnings expectations. Reported EPS is $0.38, expectations were $0.34.

Operator: Good day and thank you for standing by. Welcome to the Fortinet Q2 ’23 earnings call. At this time, all participants are in listen-only mode. After the speaker’s presentation there will be a question-and-answer session. [Operator Instructions] Please be advised that today’s conference is being recorded. I would now like to hand the conference over to your speaker today, Peter Salkowski, Senior Vice President of Finance.

Peter Salkowski: Thank you, Trace. Good afternoon everyone. This is Peter Salkowski, Senior Vice President of Finance and Investor Relations at Fortinet. I am pleased to welcome everyone to our call to discuss Fortinet’s financial results for the second quarter of 2023. Speakers on today’s call are, Ken Xie, Fortinet’s Founder Chairman and CEO and Keith Jensen, our Chief Financial Officer. The live call that will be available for replay the webcast on the Investor Relations website. Ken will begin our call today providing a high level perspective of our business. Keith will then review our financial and operating results for the second quarter of 2023 before providing guidance for the third quarter of 2023 and updating the full year.

Will then open the call for questions. During the Q&A session, we ask you to please limit yourself to one question and one follow up question to allow others to participate. Before we begin, I’d like to remind everyone that on today’s call, we will making forward-looking statement. And these forward looking statements are subject to risks that 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 statement reflect the opinions only as of the date of this presentation and we undertake no obligation and specifically disclaim any obligation to update forward-looking statement. Also, our references to financial metrics that we make today on today’s call are non-GAAP unless stated otherwise.

Our GAAP results and GAAP to non-GAAP reconciliations are located in the earnings press release and in the presentation that accompanies 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 there on a year-over-year basis unless noted otherwise. I will now turn the call over, Ken.

Ken Xie: Thanks, Peter. Thank you Were we weren’t for joining today’s call to review our second quarter 2023 results. Total revenue in the second quarter increased 26%, driven by strong revenue growth service, which 30% for the second consecutive quarter, with 34% growth in existing subscription and scription and non-FortiGate product row over 45%, which is nearly $2 billion annual run rate, building growth of 18%, leads to more normalized product revenue growth of 18%. We believe our building performance reflect large enterprise concern with the macro environment in addition to some uniquely indigestion after two years of elevated 30%-plus product building growth during the supply chain shortage. According to IDC’s latest quarterly security tracker, in addition to having the number one unit in firewall category for 10 consecutive year with over 50% market share, Fortinet is now the market share leader in both unit and revenue.

Based on the latest Westland Advisory on Security and Cybersecurity report, Fortinet was named but only ITOT network protection platform leader. We are currently one of the top and the fastest growing OT security vendor in the market that Westland Advisor expect to grow to $33 billion by 2030. Including our success line with our broad integrated platform, our proprietary ASIC security processor, and our ability to converge network and security both on prem and in the cloud across a single fully OS operating system, to leverage these advantages and drive future growth in addition to our leading network security solution, we have increased our go-to-market investment in universal setting as demand IoT security, cloud security and security operations.

And we were dedicated more resource to support hybrid infrastructure and hybrid world. Today we are announced new FortiGate 90G, our first next generation firewall after [Indiscernible] with the new security process of flat FortiASIC, that delivers industry-leading security function, performance, stability and power efficiency and cost effective price. The FortiGate manages the fully integrated with our FortiGuard AI-power security service, and has secure computing reaching up to 16 times greater than average of our competitors similar price model are using over 90% less power than competing solution. We also announced two new SD-WAN service under the performance monitoring service to simplify operation and enhance digital experience as well overlay service to facilitate rapid deployment, redundancy and a seamless interconnection of location with for FortiSASE using SBA technology.

This new SD-WAN service showcase our commitment to expanding our service leverage our leading installation base for additional future growth. We see our single vendor SASE solution opening a large new market, and one where our sizable SD-WAN installed base can be leveraged as a significant market access point. Together with newly announced SD-WAN service, we plan to accelerate our global point of presence pop deployment, with a dual strategy of investing in our own pops as well as working with service providers. Fortinet recently announced results of our IT-dependent analysis by Forrester, of the cost saving and benefits of the current FortiGate next gen firewall and FortiGuard AI powered secure surveys within enterprise datacenter, which include more than 300% return on investment over three years, pay back in six months and 90% reduction in time spent on manual updates.

In addition, an independent analysis by Enterprise Strategic Group established that the customer who deployed Fortinet Security operation solution, such as FortiEDRand for the FortiNDR reduce their time to detect and respond to incidents from an average of three weeks to one hour. This demonstrates the substantial impact that artificial intelligence machine learning and the integration of a Fortinet Secure op fabric product that have operations ability to secure today’s rapidly expanding attack surface. Finally, new developments in AI such as generative engine show a lot of promise to various applications of the security. We believe AI technologies can help us significantly improve productivity, and can be scaled to a large customer base in areas such as malware detection, thread hunting, event correlation and automation, as well as safety network design and troubleshooting.

Before turning the call over to Keith, I would like to thank our employees, customers, partners and suppliers worldwide for the continuous support and power. Keith.

Keith Jensen: Thank you, Ken. And good afternoon everyone. Let’s start with the key highlights from the second quarter. Billings growth was 18% as well as product revenue growth, service revenue growth held firm at 30%, resulting in total revenue growth of 26%, OT and SD-WAN revenue continue to perform well as revenue from these products were up 60% and 40%, respectively. In a sign of our strength in the small and midsized customer segments, we added a record 6,500 new logos. Operating margins of 26.9% exceeded the high end of the guidance range by 140 basis points. Free cash flow was strong at $438 million, representing a margin of 34%, benefiting from the deferral of certain cash tax payments to the fourth quarter. Looking at buildings in more detail buildings of $1.54 billion were led by non-FortiGate billings over 30% growth, representing 34% of total billings.

Non-FortiGate billings growth was driven by networking FortiGate VM, NAC [ph] and cloud. And as Ken mentioned, non-FortiGate is nearing a $2 billion annual revenue run-rate. In terms of industry verticals, government and manufacturing topped the list as a percentage of total billings, with manufacturing up almost 50%, government and construction were up over 30%, while service provider and retail were up 1% and down 5% respectively. Retail was impacted by a very difficult compare, as the industry vertical nearly doubled in the year earlier period. Billings growth vary by GIOS with international emerging leading, followed by Europe and the LatAm. APAC and to a lesser extent U.S. enterprise were challenged by difficult prior year comparisons.

Deals over $1 million increased from 122 deals to 134 deals. Turning to revenue and margins. Total revenue grew 26% to $1.29 billion, driven by non-FortiGate growth of over 45% and service revenue growth of 30%. This was the second consecutive quarter of greater than 30% service revenue growth. Security subscriptions represent over 55% of all service revenue and continue to streak a strong increasing sequential quarterly growth dating back to Q1 of ’22 of 23% to Q2 of ’23 at 34%. Product revenue of $473 million increased 18%. Product lead times and backlogs are expected to approach normal levels in the third quarter. Total gross margin of 77.9% was up 140 basis points driven by 160 basis point increase in product gross margin to 63.5%. Product gross margin has benefited from earlier pricing actions and easing cost pressures and were partially offset by certain inventory charges.

Service revenues were 63% of total revenues and delivered gross margin of 86.2%. Higher service revenue, offset higher labor costs and increased cloud delivery costs, as we continue to expand our cloud SASE delivery models. We see our single vendor SASE solution opening a large new market and one where our sizable SD-WAN install base can be leveraged as a significant market access point. We plan to accelerate our point of presence or POP deployment, with a dual strategy Ken mentioned investing in our own POPs, as well as working with third party providers to accelerate our deployment. Operating income of $348 million, grew 36% outpacing revenue grew by more than 10 points as operating discipline resulted in significant operating leverage. Operating margins of 26.9% exceeded the high-end of the guidance range and was up 210 basis points due to the strong gross margin performance and operational efficiencies.

Earnings per share increased 58% to $0.38 per share, and also exceeded the high-end of the guidance. Looking into the statement of cash flow summaries on Slide 7 and 8, free cash flow increased 55% to $438 million. The adjusted free cash flow, which excludes real estate investments was $498 million, representing it 38.5% adjusted free cash flow margin. Free cash flow benefited from the deferral of approximately $190 million in cash tax payments. As mentioned last quarter, these tax payments together with other deferred 2023 tax payments are due to be paid in the fourth quarter. Capital expenditures were $77 million, including $59 million of real estate investments. Cash taxes on the quarter were $38 million. The board recently increased the company’s share repurchase authorization by 500 million.

And the total available share buyback authorization is now approximately $2 billion. Now I’d like to share a few significant wins from the quarter that exemplifies the strength of our broad and integrated platform. First, a global pharmaceutical leader signed an eight-figure deal without Fortinet Cybersecurity Fabric, investing in our OT aware secure networking architecture, as well as our AI ops and threat intelligence solution. Recognizing the market shift to a platform-based approach to security, this company selected Fortinet to secure its highly regulated and sensitive medical data that continues to drive global operational and financial efficiencies through our broad integrated and automated platform approach to cybersecurity. In another deal, one of the largest U.S. school districts which had recently refreshed its datacenter firewalls to FortiGate was seeking to improve its network security posture with a NAC solution that offers better visibility to the devices connected to the network.

Fortinet competed against multiple peers, and was able to win did a FortiNAC’s ease of implementation, centralized management capability and superior risk remediation, as well as the tight integration to the district’s existing Fortinet security fabric. This high seven-figure deal was the largest NAC deal in Fortinet’s history. Finally, in the seven-figure displacement in our largest FortiSASE deal ever, a large bank on its digital transformation journey, who was searching for a single vendor SASE solution for its hybrid workforce. This selected our FortiSASE solution for over 5,000 users, as it integrates SD-WAN and SASE into a holistic solution and delivers comprehensive security, both from the cloud and on prem, while ensuring consistent security policies for all users regardless of their location, and wherever applications are being accessed.

These transactions illustrate how Fortinet’s platform strategy, integrated operating systems and proprietary ASIC technology continues to resonate with customers. Given the heightened interest in AI technology, we could not do this call without discussing Fortinet’s investment and innovations in AI. Fortinet has been at the forefront of AI and machine learning innovation for many years, leveraging deep learning and artificial neural networks to power our products and security services, enabling a faster, stronger and more accurate defense for our customers. One of our first AI-powered use cases was the introduction of the virtual FortiGuard Threat Analyst. FortiGuard addresses threats in real time with machine learning, coordinated protection and is extensively used in malware detection and threat hunting.

Every time the threat is identified, FortiGuard generates threat intelligence that automatically updates defense signatures across the fabric. In cloud environments where scale and speed are critical, AI and machine learning can help security teams keep pace with threats on multiple fronts. All of this happens seamlessly and behind the scenes. Today, our platform Guest and Analyzer on average more than 100 billion events every day, to deliver over 1 billion security updates daily across the Fortinet security fabric and ecosystem. While many of our competitors OEM their security from different security vendors. Our AI-driven FortiGuard threat intelligence has been built in house, which allows us to use AI across different sources. Adversaries increasingly are using AI in their playbooks to drive cyberattacks, which only increase the rapidly evolving cybersecurity threat landscape.

We continue to invest in AI and machine learning technologies across our products, including generative AI, natural language models, and other implementations to enhance, simplify and automate security for our customers. Before moving to guidance, I’d like to offer some observations about the second quarter and about the industry. Regarding the second quarter, we believe macro and certainly impacted our billing performance to average contract duration, and in the second half of June, and the elevated level of enterprise deals pushing the future quarters. We saw shorter contract duration, with the average term decreasing by 1.5 months to 28 months, creating a 4 to 5 point billings headwind year-over-year. Normalizing billings growth with a change in contract duration, yields billings growth in the low-20% range.

Having some level of enterprise deals pushed to future quarters, it’s not unusual. In Q2 ’23 however, an unusually large volume of deals that we expected to close in June, instead push to future periods. From a market perspective, CIOs continue to prioritize and invest in securing their organizations in the face of rising cybersecurity threats. We see new regulatory requirements, such as the recently announced — those recently announced by the SEC and the EU Cyber Resilience Act announced earlier this year. They will continue to provide market tailwinds as organizations further increase their cybersecurity investments to comply with new stringent cyber regulations. The cybersecurity industry remains highly relevant as CIOs prioritize cyber spending within the overall IT budgets.

As such, the longer term demand drivers for Fortinet net remained very solid. That said, we do see a return to more normal seasonality for Fortinet in the back half of the year. That’s tailwind such as the supply chain driven growth subsides. And we cycled prior period price increases. Moving on to guidance. As a reminder, our third quarter full year outlook, which are summarized on Slides 11, and 12, are subject to the disclaimers regarding forward-looking information that Peter provided at the beginning of the call. For the third quarter we expect billings in the range of $1,560 million to $1,620 million which at the midpoint represents growth at 13% and is consistent with our quarter-over-quarter seasonality prior to the pandemic. Revenue in the range of $1,315 million to $1,375 million which at the midpoint represents growth of 17%.

Non-GAAP gross margin of 75.5% or 76.5%. Non-GAAP operating margin of 24.5% to 25.5%. Non-GAAP earnings per share of $0.35 to $0.37. This assumes a share count of between $795 million and $805 million. Capital expenditures of $100 million to $130 million non-GAAP tax rate of 17% cash taxes of $25 million. And as previously mentioned, backlog is expected to approach normal levels in Q3. For the full year, we expect billings in the range of $6,490 million to $6,590 million, which at the midpoint represents growth of 17% and apply slightly below normal seasonality in Q4. Revenue in the range of $5,350 million to $5,450 million, which at the midpoint represents growth of 22.3%. Service revenue in the range of $3,350 million to $3,410 million with the midpoint represents growth at 28.2%.

The service revenues guidance implies product revenue growth at 13.5%. Non-GAAP gross margin of 75.25% to 76.25%. Non-GAAP operating margin of 25.25% to 26.25%. Non-GAAP earnings per share of $1.49 to $1.53, which assumes a share count of between $795 million and $805 million. Capital expenditures of $335 million to $385 million due to our continued cloud data center and facilities investments. Non-GAAP tax rate of 17%, cash taxes of $460 million with approximately $380 million in the fourth quarter. We continue to execute our long-term strategy and remain confident in the strategy and our solutions. While it’s a little early to be providing guidance for next year, we would expect our near term performance or represents a short term trough.

Given our confidence in our solutions, our offerings — and taking into account that growth comparisons will ease as we move through 2024 that this early stage we would expect billings growth to approach high-teens by the fourth quarter of 2024. And with that, I’ll now hand the call back over to Peter to begin the Q&A session.

Peter Salkowski: Thank you, Keith. Operator — just one quick reminder before doing the Q&A, if you can please limit yourself to one question and one follow up question. Operator, you can open the call.

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Q&A Session

Operator: Thank you. [Operator Instructions] Our first question is from [Indiscernible]. Your line is open.

Unidentified Analyst: Good afternoon. Thank you for taking the question. Ken, I think you noted that — and Keith commented to it as well, reflected — I guess, the billings performance and guidance reflects enterprise concern about the macro. Could you give a little bit more color there on what you saw from a macro perspective? And I think you pointed to a weak service provider business. I think investors might draw parallels to what they saw at Juniper last week on the carrier side. Maybe if you could include a few thoughts on how dynamics there may be similar or different with regard to what you see? And then I have a follow-up.

Ken Xie : Sure. I think for the carrier service provider, we do see they’re probably a little bit behind on offer some surveys because the carrier service provider, if you look back 10-15 years ago, is our biggest market. It’s like about 30% market share comes from the carrier service provider. But nowadays, security need additional service like some SASE, all these function — function in the SASE, which service provider kind of behind, so we’re still working with them and closely try to help them accelerate the service. At the same time, we’re also starting to invest a little bit more self, which also, like together with the new service we announced today, the two new SD-WAN service, we feel invest in certain infrastructure that will help in drive a lot of new service going forward in the security space, and also in helping service providers to kind of accelerate some of their security service beyond the traditional security service.

Keith Jensen : Yes. I would probably add to Ken’s comments, particularly as we talk about service providers and some of the other verticals and customer segments. And I think there are some lessons that we can see from, for example, manufacturing, which did extremely well in the quarter. They continue to have — I feel they think they’re under pressure in the threat environment, so you see them spending fairly richly. It’s still a surprise, If you look at the government sector which was strong also, they have governments in the — they have budgets on the slowing economy that maybe some of the other industries don’t. And at the other end of the spectrum, Ken talked about service provider, and people I think are aware of that story there more broadly.

But also retail, I think retail is really a very clear indicator of a vertical that can be one of the first that is sometimes impacted by a slowing economy. But also, Ken made reference to this in his comments, this concept of digestion. A lot of purchasing around SD-WAN technologies and implementations. A year ago, you saw very, very high growth a year ago. And now going through a digestion period, such as the point that it’s actually negative growth in the retail vertical.

Ken Xie : We’re also interested in some cloud provider also started getting in the security space, which also kind of confused some of the enterprise customer. So that’s also sometimes they take a little more time to evaluate our different solutions. So we do believe this is a hybrid approach on-premise in the cloud that will be best for the customer, even the cloud probably much more expensive or cost an average about 3x to 5x more expensive compared to on-premise, but it’s — combined altogether probably will be the best solution for customers.

Unidentified Analyst: Got it. That’s helpful. And maybe a quick follow-up for Keith, I think you talked about a reinflection to high teens billings growth next year. How does performance this quarter and your outlook for the rest of the year impacted 2025, I guess, $10 billion billings target that you’ve previously thrown out there?

Keith Jensen : Yeah. I think that as we go through the second half of the year and we enter into our normal planning cycle for 2024, I think that will be a logical output at that point in time to think through what we’re seeing in terms of our 2025 targets.

Unidentified Analyst: Okay, that’s helpful. Thank you.

Operator: Thank you very much for your question. Our next question comes from Gabriela Borges with GS. Your line is open.

Gabriela Borges : Hi, good afternoon. Thank you. Keith, I want to say on the medium-term outlook, your comment on high-teens billings growth by 4Q ’24, if I heard it right. Maybe just talk us through how you thought about derisking the six-month and the 18-month kind of outlook? And what are some of the leading indicators you are looking to determine when billings growth and product revenue will trough? Thank you.