Fortinet Inc (FTNT) 2010 Q2 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Fortinet Q210 Earnings Announcement call. (Operator Instructions). And, as a reminder, this conference is being recorded.

And now your host for today's conference, Ken Goldman, Chief Financial Officer. Sir, please begin.

Okay. Good afternoon and thank you all for joining us on the conference call to discuss Fortinet's financial and operating results for the second quarter, 2010. Joining me on this call are Ken Xie, President, Founder and CEO of Fortinet, and Michelle Spolver.

In terms of the structure of the call, I will begin with a review of our operating results before turning the call over to Ken to provide additional perspective on the performance of our business. I will then conclude with some thoughts on outlook for third quarter and full-year 2010 before we open up the call to questions.

As a reminder, today we're holding two calls. Following this call, we will hold a second conference call to provide an opportunity for the financial analysts to ask more detailed financial questions. That call will begin at 3-30 p.m. Pacific time. It will also be webcast from our Investor Relations website and is accessible at detailed earnings release.

Let me also first read this disclaimer or Safe Harbor statement. Please note some of the comments we make today are forward-looking statements, including statements regarding our financial guidance for the third quarter 2010 and full year, as well as statements regarding the momentum of the business and its ability to execute and drive growth in coming quarters, the performance of our government business, and the adoption of UTM solutions across sectors and geographies.

These forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those projected in forward-looking statements. Please refer to our SEC filings, in particular the risk factors described in our registration statement, Form S-1, our 2009 Form 10-K and our first quarter 2010 Form 10-Q for more information on these risks and uncertainties and on the limitations that apply to our forward-looking statements. Copies can be obtained from the SEC or by visiting the Investor Relations section of our website.

All forward-looking statements reflect our opinions only as of the date of this presentation and we undertake no obligation to revise publicly or release results of any revision of these forward-looking statements in light of new information or future events.

Also note we are discussing certain non-GAAP financial measures on this call. Our GAAP results and GAAP to non-GAAP reconciliations can be found in our earnings press release and on slides 12 and 13 of the presentation that accompanies today's prepared remarks.

Please refer to our website at investor.fortinet.com for important information, including our earnings press release, issued a few minutes ago, and slides accompanying today's prepared remarks. A replay of this call will also be available on the website. Please note that we routinely post important information on the Investor Relations website and we encourage you to make use of that resource.

Okay. I went through that fast. So now let me talk to our second quarter results.

I will review Fortinet's second quarter financial results. Second quarter was outstanding across the board from an execution standpoint. Performance was primarily driven by an increase in the number of customer wins across all key industry verticals and geographies, sustained growth and larger enterprise deals and traction on new products, combined with an ongoing focus on expense control.

Our solid execution translates into substantial improvement in all of our key operating metrics and enabled us to exceed the high end of our guidance from a billings, revenues and profitability perspective. The underlying strength of our business during the quarter is evidenced by superior performance in our leading indicators, including billings, product revenues, number of large deals and cash flow.

I am particularly pleased with the momentum in the enterprise segment where we had a number of notable customer wins. I will provide details of several enterprise transactions a little later in this call, but overall there are several factors I would like to highlight that have contributed to our enterprise success.

First, our recent hiring efforts, which have been more focused on driving enterprise and service provider businesses, have yielded tangible results.

Second, the recent introduction or rollout of new technology and products, such as our FortiGate-1240B, FortiGate-3950B and FortiGate-60C high-performance UTM appliances, and FortiOS 4.0 firmware enhancements, which continue to differentiate us from our competition and enable us to attract and retain larger customers.

Finally, we are realizing the benefits for improved public visibility and recognition due to our recent IPO.

In addition to Fortinet's outstanding execution, I am very encouraged by the solid demand we are seeing in the overall security market and, specifically, the increasing trend to UTM solutions. We continue to see IT budgets freeing up and many organizations are returning to more normalized traditional sales cycles, both of which have contributed to our strong billings and resulted in improved visibility.

Furthermore, I'd like to note that we continue to see solid demand across all of our geographic regions. Despite the fact that several European economies are facing greater challenges, we experienced healthy growth from this region, including several enterprise and service provider wins for the quarter. In fact, it may represent our highest-growth region in terms of billings.

So, in summary, we had an exceptionally strong quarter and with that said, we are mindful of the dynamic global environment and, therefore, will remain focused on aggressively growing our top-line performance and market share, while prudent in controlling expenses and working to increase operating margins.

With that, I will begin by turning to the income statement, which you will see on slide two. Billings were $90.3 million, an increase of $21.5 million, up 31%, compared to the same period last year, Q2, and up 14% from Q1, and well exceeded our guidance of $81 million to $83 million.

The approximate billings growth by region -- Americas, approximately 35%; EMEA, 39%; and Asia-Pac, 14%. And, as you can see from our product segmentation on slide three, we have realized the benefits of new and introduced high-end products as we saw the high end account for 35% of product billing, compared to 30% last year.

In terms of large deal sizes, the number of deals over $100K for the second quarter was 96 compared to 67 in Q2 of last year and 84 in Q1 of this year. Over $250K was 32 versus 19 in Q2 of last year and 22 in Q1 of this year. Then we have a new metric, the number of deals over $500K for the second quarter was 18 and that compares to 7 in Q2 of last year and 8 in Q1. Additionally, we had several deals over $1 million.

Given the traction we have had in the enterprise segment, let's take a moment to highlight some of the larger enterprise deals. One win was with a Fortune 500 company which outsourced a global data center and global provider network. In this case, Fortinet displaced Check Point with additional products and projects to follow, including replacing McAfee's web content filtering and end-point security agents. We were selected due to our integrated approach to security.

One of the largest deals in the quarter was with a large foreign government entity, which was looking to secure multi-task video streaming within a VPN tunnel. Due to our superior customer service and ability to customize a solution, we beat out Cisco for this business. Products that ship for phase one of the project included our core FortiGate products, in addition to FortiManager and FortiAnalyzer.

Let me now turn to revenue. Total revenue was $76.3 million, which represented growth of 24% on a year-over basis and exceeds the high end of our guidance of $71 million to $73 million. Revenue growth will tend to lag billings growth due to the deferral of services.

Taking a closer look at revenue, there were several verticals that contributed to the strength in the second quarter, and I will highlight some of the key wins in these verticals. For example, we continued to gain traction in financial services.

One example is a win with one of the top financial services content companies that wanted to install a low-latency firewall solution in order to deliver content to the market faster. Fortinet beat out Juniper and Cisco due to the raw performance of our FortiGate appliances.

Another example of a financial vertical win was with a stock transfer company in the U.S. where we won it on UTM versus a point solution approach. We won this deal based on our ability to deliver a broad, integrated UTM solution with significant better performance, scalability and ROI over deployment of individual point solutions.

Additionally, we continue to see strong momentum in the retail sector, with numerous key retail wins during the quarter. Among them were a deal with one of the largest food-- retail food chains in the US, beating out SonicWall and WatchGuard based on UTM and [PSEC] appliance capabilities across over 4,000 locations.

We also closed an infrastructure refresh deal with a large retail chain, beating out SonicWall, who was the incumbent. We won the business due to our superior technology with respect to [PSEC] appliance across over 1,500 locations. Both of these deals are phased, multi-year deployments, so we will continue to benefit from these new customers in coming quarters.

Finally, our service provider business remained very strong, with key wins with repeat customers, including some of the largest service providers in the US and Europe, who are using our high-end FortiGate products to secure their infrastructure, add datawidth and offer new or expanded managed service offerings.

In a two-part deal last quarter, a leading telecommunications company in Europe purchased hundreds of FortiGate, FortiSwitch, FortiManager and FortiAnalyzer products to deliver two separate cloud-based security offerings, a managed UTM security for commercial customers and, as well, what will be the country's biggest content filtering service.

This will provide managed security to approximately 35,000 schools across the country who are using our firewall, URL filtering, anti-virus and application control technology. We won this $2 million-plus deal based on our breadth of security functionality, on our virtual domain technology and large scale management abilities.

Additionally, one of the top telecommunication companies in the world added to its existing Fortinet deployment wit additional FortiGate 5000-series appliances. New appliances either add datawidth or provide additional functionality to its managed firewall services. This $1.5 million-plus deal closed in the Americas region.

Now breaking out our revenue on a geographic basis, you can see Fortinet's diversified business profile on slide four. On a geographic basis, Fortinet saw strong revenue growth in all three regions during the quarter (inaudible) in slide five.

Just as a reminder, the geographic split of revenues is calculated using the bill-to address.

In the Americas, we achieved $28.9 million compared to $22.6 million in the prior year, representing an increase of 28%. This was driven by several factors.

First, IT spending remained solid during the quarter, as we continue to see projects springing up.

Second, we continue to benefit from recent investments made to strengthen our sales infrastructure. This has led to an increase in the size and profile of recent customer wins, specifically with the larger enterprise and service provider customers. Key wins in this area include a top-five telecommunications provider, two leading financial services organizations, a Fortune 500 office product manager, a leading electronic distributor and a public health agency.

Third, we also saw solid growth in SMB resulting from both an increase in sales people and channel focus, as well as large branch deployments that included our lower-end appliances.

In EMEA, we recognized $29.5 million versus $23.0 the prior year, increasing 28%. We continue to see steady demand from Europe, despite the general concerns over the economy. During the quarter, we benefited from several enterprise wins in Europe, including two deals with major European telecom service providers.

As we had mentioned before, we have been able to manage through challenging economic environment, specifically during late 2008, early 2009. This demonstrates that network security is a must-have for enterprises of all sizes, even in economic downturns, as well as speaking to the value proposition and quality of Fortinet's UTM solutions and the trend to UTM consolidation and increasing security market share.

In Asia-Pacific we did $18 million compared to $15.7 million the prior, increasing 14%. Billings were well dispersed across the region. We saw continued growth in Japan after an especially strong seasonal Q1, which was their fiscal year end in Japan.

We still have to work to do to leverage some of the growth opportunities, however, in Australia and New Zealand and are adding to our management teams there.

Let me switch now to product revenues. We reported $31 million during the second quarter, an increase of 27% on a year-over-year basis and up 14% from Q1.

You'll see from slide six the revenue breakdown between products and services. As I mentioned last quarter, we view product revenue as an important leading indicator and, therefore, this strong growth bodes well for our service business in the coming quarters.

Growth in product revenue was primarily driven by the greater visibility and improved [granular] transparency from being a public company, as well as the introduction of new products over the past year.

In addition to the strong growth of our core products, we also gained traction on non-FortiGate products in the quarter. For example, we sold FortiMail and FortiClient to a large European manufacturer which has been a FortiGate customer for a number of years. We beat out major competitors, based on our ability to provide a very comprehensive solution for the UTM mail and end-point security.

New shipment growth was in line with product revenue growth. We saw significant growth across all product segments with consistent pricing, particularly in the mid-range and high-end.

Services revenue was $41 million in the second quarter, compared to $33.5 million in the quarter ago, up 22%. We continue to see a positive trend in longer-term deals, as we execute on our strategy to focus on larger enterprises.

This trend has led to improved visibility in our business. We have seen larger accounts with more clients sign up for longer service periods.

As mentioned in prior quarters, a reminder that service revenue consists of our FortiGuard security subscriptions and FortiCare support subscriptions, which our customers typically purchase together.

We expect that services revenue to increase over time due to our deferred revenue model and our increased growing installed base of security platforms. We are also reaching our 70% long-term renewal rate (inaudible) of service offerings faster, as we have seen improved rates in the higher-end renewals of $5,000K and greater accounts.

Our product (inaudible) due to enhanced recording, which provides better visibility information on our accounts. As I mentioned last quarter, there continues to be good opportunity for improvement on the lower-end renewals of what we call $5K and below.

Finally, our ratable revenue was $4.3 million and increased 27% year-over-year.

DSOs -- (inaudible) revenue quality DSOs was 71 days, up a bit from 64 the prior year, but in that range of 65 to 75. Our aging in our receivables continues extremely good, with no credit quality issues. We have seen higher billings and increases in deferred revenues in comparison to recognized revenues, which has contributed to a slightly higher DSO.

And, as noted, our deferred revenue balance increased to $225.5 million, which is up $40.5 million, or 22%, year-over-year and $14 million, up 7%, versus the first quarter.

We didn't have any changes in our accounting treatment.

We increased headcount slightly, ending the quarter with 1,287 employees compared to 1,246 in the first quarter and 1,151 in Q1 of last year. The majority of the headcount increase was sales related and we will continue to invest in this area to ensure we are well positioned to capitalize on future growth and achieve market share gains.

As you can see on slide seven, Fortinet is a globally diversified business with headcount dispersed worldwide and just 24% in the US.

To show and demonstrate the (inaudible) leverage, we grew our billings by 21%-- I'm sorry, by 31%, and our revenues by 24% year-over-year, compared to a 12% increase in employee headcount. This contributed to a 4 point year-over-year increase in non-GAAP operating margins.

And, as you can see on slide eight, our revenue per employee increased to a record $241,000 in the second quarter, up from $215,000 in the second quarter of last year.

Now let me talk about income statement cost ratios. The numbers that I'm about to report will be all non-GAAP.

So the non-GAAP gross margin was 34% in the second quarter, which is flat compared to Q2 '09, slightly above Q1, and within our target range of 71% to 74%.

Product gross margin was 62% for Q2 compared to 61% in Q2 of last year, pretty comparable. Non-GAAP service gross margin was 84% compared to 85% last year.

In terms of non-GAAP operating expenses -- again, these are all non-GAAP -- we had $44.4 million in Q2, an increase of 17% year-over-year. And as a percentage of revenues, total non-GAAP expenses during Q2 were 58% compared to 62% in the same period last year.

R&D expense increased 20% year-to-year to $12.1 million. As a percent of revenues, R&D was 16% in both Q2 of this year and last year, which is within the range of our long-term model.

We had a 6% increase in R&D headcount, with merit and other increases, and there was an 11% increase year-over-year over the Canadian FX rate to the US.

Sales and marketing expense increased 14% year-to-year to $26.9 million. As a percent of revenues, sales and marketing were 35% compared to 39% in the prior year and so we continue to see good leverage in terms of our sales and marketing.

G&A expense increased 32% year-to-year to $5.4 million and as a percentage of revenues Q2 G&A was 7%, basically flat. We are incurring legal expenses to support various patent litigation matters.

In terms of profitability -- again, all these are non-GAAP -- non-GAAP operating income was $12 million, which represented a non-GAAP operating margin of 16% compared to $7.4 million and 12% operating margin last year and 13% operating margin the first quarter of 2010.

This came in well within our guidance, due to tight expense control, in addition to better-than-expected revenue. Other income increased $0.4 million, primarily due to higher interest on our higher cash balances.

Pro forma tax rate was 35% compared to 13% in the prior year period. Based on the annual estimate for geographic split of income, as well as various tax credits we expect to achieve in various locations, the Company plans to use a 35% tax rate for the year.

Non-GAAP net income was $8.1 million in Q2 compared to $6.7 million in the second quarter of 2009. Diluted earnings per share was $0.11, which exceeded our guidance range of $0.08 to $0.09 and compares to $0.10 in the second quarter of 2009.

Compared to last year, the variations include the higher tax provision of 35% versus 13% last year. Diluted shares outstanding were 75.6 million compared to 64 million the prior year. This growth of 11.6 million increase in weighted shares is primarily related to shares issued in the IPO and a 1.1 million increase in the cap ratio of diluted employee stock options due to the higher market value of Fortinet stock. Using a comparable tax rate and number of shares as Q210, EPS in the second quarter of '09 on a non-GAAP basis would have been $0.07.

As we mentioned at the beginning of the call, the full reconciliation between our non-GAAP and GAAP results is in our earnings press release and on slides 12 and 13 of the presentation.

In terms of GAAP second quarter results, GAAP net income was $6.9 million compared to $4.6 million for the second quarter of 2009. Second quarter of 2009 also included $4 million (technical difficulty). GAAP results in Q2 included a $2.3 million stock-based compensation and approximately $600,000 in company-paid payroll taxes from the exercise of employee stock options. The $600,000 was not excluded from our non-GAAP numbers.

GAAP diluted earnings per share was $0.09 compared to $0.01 in the last-- in the period last year.

Let me turn quickly to the balance sheet. And you'll see some of these-- the balance sheet highlights on slides nine, 10 and 11.

Cash remains an important indicator to the health of our business. We ended the quarter with $309 million in cash, cash equivalents and short and long-term investments or over $4 per fully diluted share. The $28 million increase from 1Q 2010 was primarily due to cash generated from operations, in addition to the exercise of stock options in the quarter.

Cash generated from operations was $18 million in the second quarter, our 17th consecutive quarter of generating positive cash flow from operations exclusive of one-time items. I would make a comment that cash flow from operations is primarily the sum of non-GAAP operating income plus depreciation, net change in deferred revenues, accounts receivables and accounts payable.

During the second quarter of this year, free cash flow was $17 million, up 20% versus second quarter of '09, and during the first half of 2010, we generated $38 million in free cash flow, a 40% increase over the first half of 2009.

Some other balance sheet highlights -- AR balances increased $8.5 million to $59.8 from $51.3 million in 1Q. We achieved (inaudible) for the quarter of $80.6 million and, as I said before, aging continues to be very, very current.

Inventory increased to $12.9-- I'm sorry, $12.1 million from $9.9 million in 1Q. The increase in inventory was due to parts orders for early 3Q delivery, as well as the ramp of new products to support 3Q shipments.

Working capital increased $6 million to $148 million compared to 1Q. The balance sheet-- I should also point out the balance sheet reflects $56.6 million in long-term investments. If this was included in short-term investments, working capital would have increased to $204.9 million in the second quarter.

Debt to (inaudible) was 6.7. I talked about deferred revenue of $225.5 million, up 22% year-over-year and 7% sequentially. I would point out, short-term deferred revenues increased to $154.3 million, up 18% year-over-year and up $9.1 million or 6% versus 1Q. And, as noted, we continue to see increases in long-term deferred, which increased to $71.2 million, up 31% year-over-year and $4.9 million, up 7% versus 1Q.

Thus, in summary, our strong second quarter results continue to demonstrate our solid execution with meaningful improvements across all our key metrics. We continue to generate strong increases in total billings and product revenues. This performance is highlighted by the growth in our high-end product segment, large enterprise and service provider wins, large new high-profile accounts and strong growth globally.

Our non-GAAP operating margins of 16% came in well above expectations, which continue to demonstrate the leverage in our model, resulting from strong revenue gains and focused on expense control.

Finally, we continue to generate substantial cash flow, driven by our operations.

Looking ahead, we are well positioned to continue to grow in excess of the market due to new product launches, increasing sales infrastructure and greater market visibility, while we maintain prudent cost and expense controls.

I'd like to now turn the call over to Ken, who will provide some additional color on the security landscape and highlight some of our second quarter business accomplishments. I will then come back to provide third quarter guidance and our updated outlook for the full year and then we'll take your questions.

Okay. Thank you, Ken, and thank you, everyone, for joining us on the call.

As Ken mentioned, Q2 was a great quarter all around with growth across all the metrics, including billing, revenue, cash, profitability. So we executed quite well, combining expense control with the growth of the business and driving of innovation.

So our strong sales results were driven by a few factors. First, we continue to do very well in high-end, winning a number of large deals with service providers that are using our products to offer (inaudible) cloud-based managed security service, as well as protect their own data center.

Our position in this sector is particularly strong. We have counted 10 of all the top 10 Fortune Global Telecommunications company as Fortinet customers now.

So second, the result of our sales for investment and vertical focus restructure continued to pay out this quarter. So our enterprise business is doing quite well, with several marquee customer wins. As Ken mentioned, the US retail sector was strong for us, fueled by the (inaudible) driven win for large branch deployments with the leading retail chains.

We also continue to make traction in the financial service sector, a vertical market we began to focus on with a dedicated team leader last year. One of the few key finance service wins was the world's leading stock exchange that requires firewall for very low latency, zero packet loss and very high throughput to protect its real-time trading infrastructure. We won this deal over (inaudible) fire-wall provider Juniper and Cisco due to our superior technology and unparalleled performance.

While not directly impacting Q2 results, later in the quarter of Q2, we further enhanced our sales force with the addition of a new healthcare vertical focus team and a new (inaudible) VP, plus a new team leading the Australian/New Zealand market.

(inaudible) the sales of our non-FortiGate complementary products also growing well. Although the total grows faster than the FortiGate product line, but it's still considered a small portion of all of our revenue. So we closed several deals that including all these non-FortiGate products.

One of the deals is a multi-- it's a big deal with a multi-billion-dollar foreign infrastructure provider, which implemented our intelligent transportation system. So we beat Cisco, Check Point and (inaudible) for this comprehensive security deal, which included FortiGate, FortiMail, FortiDB, FortiWeb, FortiClient and FortiManager and FortiAnalyzer.

Also, again, (inaudible) innovation is still in our core DNA and success, so we continued to innovate during Q2 and announced quite some new products to differentiate Fortinet from others in the market. So we announced the FortiGate-60C and FortiWiFi-60C, which is the first to utilize Fortinet's innovation FortiASIC system on a chip architecture we pioneered and provide SMB and enterprise branch office with affordable, high-performance security solution.

And also the FortiGate-3950B, which is the highest performance firewall product on the market, delivers 120 gigs throughput at exceptional price performance to the enterprise. The FortiGate-3950B was recently awarded Best of Show at Interop Tokyo.

We also received more third-party certifications, which validate the strength of our technology and position in the market. So this included the ICSA web application firewall certification for our FortiWeb appliance, the Virus Bulletin VBSpam Award for the FortiMail appliance and also the Common Criteria EAL 2-plus certification for the FortiMail appliance.

In closing, I'm pleased with the second quarter's result and feel confident of our ability to continue to grow and drive innovation in the market. The trend towards Unified Threat Management solutions is increasing across all sectors and all geographies and as the pioneer and market leader, Fortinet is well positioned to continue to win.

Now let me turn the call back to Ken Goldman, who will discuss our finance outlook for Q3.

Thanks. Before doing guidance, let me remind you the guidance consists of forward-looking statements and please keep in mind my earlier comments regarding such statements.

First of all, I will begin with our estimates for third quarter. We are targeting billings estimates of about $87 million to $89 million, which at the midpoint represents year-over-year growth of approximately 24%. It does take into account what we expect to see in terms of European seasonality in Q3.

Total revenues estimated range of $75 million to $77 million, with product and services revenue mix comparable to second quarter. Gross margin again in the 73%, plus or minus a point, range.

Non-GAAP operating margin in the range of 15% to 16%, which takes into account we expect to continue to invest in sales headcount and R&D. And non-GAAP earnings per share in the range of $0.09 to $0.11, which takes into account an expected diluted share count of approximately 76 million to 77 million and 35% tax rate.

For the full year, we are raising our guidance due to the strength of our second quarter results, in addition to the momentum we see in our business. We now expect billings to be in the range of $350 million to $360 million, total revenue to be in the range of $300 million to $305 million, which at the midpoint represents year-over-year growth of approximately 20%, up from our previous guidance of 17%. Note that the lower end of the range is at the prior high-end guidance.

In terms of non-GAAP EPS, we expect that to be in the range of $0.39 to $0.42, taking into account an expected diluted share count of 76 million to 77 million for the year. That's up from our prior guidance of $0.33 to $0.37 per share.

We now expect free cash flow to be in the range of $60 million to $70 million, which is up from our previous range of $50 million to $60 million and, again, the new low end of the guidance equates to the prior high-end guidance.

The number of variables and related timing continues to work with working capital contributes to us providing a relatively wider range.

In closing, this is the third quarter since we have been a public company where we have outperformed on a relative and absolute basis. Moving forward, I believe that we remain very well positioned to grow faster than the industry, driven by new products, expansion of our sales coverage and heightened market visibility.

We remain confident in our ability to continue to execute our growth strategy and, in turn, build shareholder value over the longer term. We'd like to continue to thank our employees for their dedication, our customers for continuing to partner with Fortinet and our shareholders for your ongoing support.

With that, I'll turn it over to the operator and we will begin the Q&A session.

Thank you, sir. (Operator Instructions). Our first question is from Robert Breza of RBC Capital Markets. Please begin, sir.

Hi. Congratulations on the quarter. Ken, I was wondering if you could comment just specifically as you look at the high end and what's driving those large deals. Is it additional new boxes taking more applications? What's really driving those large deals? And then, just as a followup, could you comment on what you're seeing in the government space? Thank you.

Let me take the first and Ken may actually want to (inaudible) and talk about the government.

I think on the large deals, like we said-- now we tried to give color on several of them. I really think it's both-- it's probably-- it's really three things. One is we continue to bring out better and high performance products. The 3950 is a good example of that. Two is we continue to add sales coverage that's really focused in both the enterprise and service provider space, particularly growing that organization out in the US and continue to see better wins in Europe on that. And then I do think the-- sort of the market visibility of the Company, sort of our confidence in going after these larger accounts and aggressiveness in growing after these large accounts, I think all of that has contributed to our growth there. And it's a focus for us.

In terms of government, we have work to do there. I think Ken talked about we are adding some folks there. We are hopeful to do better in the federal government than we have been doing recently and that's a major opportunity for us, but we have work to do there.

I don't know, Ken, if you want add anything?

Yes, I agree with Ken Goldman, really. So the sales force (inaudible) is on the vertical market, which should give us good enterprise wins, and, also we do see a lot of big enterprise (inaudible) refresh their old firewall structure with the UTM, which is in the last two years kind of on hold, because the whole economic environment, now starting to open up to getting the infrastructure replaced and replace the old one, old firewall.

So that's really kind of driving some growth. But also, as a public company, it's more visible and gives the customer more confidence, also more credit to use our products.

Great. Thank you.

Thank you.

Thank you. Our next question or comment is from Adam Holt of Morgan Stanley. Your line is open. Pardon me, Adam, please check your mute button.

We know you're there, Adam. Come on.

Sorry about that. We had our lines crossed there. I had a couple of questions.

If you look at the European business, it was obviously an area of strength and we're starting to get some cross-currents there in terms of the end market. Can you talk a little bit about what you saw in Europe and what you think-- what you factored into the guide, if you will, which is, obviously, a little bit more constructive.

Yes, I think the-- we saw a good business in Europe right from the get-go of the quarter. I mean, as I think about how we started and our performance, I mean, we were feeling better and better about Europe and its ability to execute, obviously, throughout the quarter. So we didn't see any, really, signs of slowness or perturbations, if you will, by the general uncertainty in Europe as yet.

The-- and so I think what we tried to do in terms of thinking about Q3 is we took into account what our internal forecasts are and the concern that, perhaps, there will-- we will see seasonality this quarter, this year, in Europe, maybe even more so than we have in the past, but that's sort of a guesstimate by us in terms of what we're seeing.

I'm not trying to represent that we're seeing business necessarily tail off as much as we're just saying we expect to see normal seasonality. I mean, you will have a number of our folks and the customers on vacation late July and early August and so we're taking that into account.

A couple of questions about the competitive environment. It looks like with the strength on the enterprise side you might have seen average selling prices move here. Can you talk a little bit about that?

And where have you seen your win rates improve over the last three to six months? You're clearly outpacing the market. Where are you seeing those share gains.

Well, [I'll make a couple of comments] on the share gains. I think the reality, as I look around, I mean, in general, the security business is doing well. I mean, others are reporting good numbers, too, and so I think the thing to take away is the original-- the activity levels, overall, are quite strong. So that's the first point. And so we are winning more, but it's also a good industry, so I think you have to context that.

In terms of pricing, for us it's always a mix. I mean, we-- we're seeing a lot in the SMB space and so we're seeing a high number of units in that space, which will affect our overall ASP, if you will, while at the same time more and more go to the higher end, but you don't have as many units.

So, when we look at ASP, we look at the various ranges and the overall ASP is pretty consistent. And I would have to say our goal, honestly, is to grow units. And so not only do we want to grow the high end, but we are very interested in growing the total units and the volume. We haven't shown a number, but we're probably well over 600,000 units we've shipped, appliances we've shipped, cumulatively. And so that's a key metric for us, as well.

Last question, just on margins. Obviously, you've talked about the importance of growth relative to showing a lot of margin expansion, but at 16% in the quarter, obviously margins moving higher for next quarter, we are seeing quite a bit of leverage in the model. Does that change your thinking about medium-term margin targets? And how are you sort of thinking about the balance between margins and growth, going forward? Thank you.

Yes. No, I think the way I've thought about it, I'll just give my own thoughts, my own opinions. Clearly, as I look at others in our industry, and I think this is a good aspect to the industry, it's an industry that's allowed decent margins, if you will. And so I think we have elevated, a little bit, our expectations as to what is achievable and the timeframe for that achievability.

Having said that, so we have moved up our margin expectations a bit, if you will. And so that's why I raised them for the year and why we raised them in Q3 from what-- we achieved better in Q2 than we did-- than we had thought.

On the other hand, we do think, particularly investing in, I'll keep on saying, in sales and R&D are critical to us and so we are forward investing, to some extent, there to grow our business. And so could we be achieving even faster margins? Yes, but we think at the increment we'd rather grow-- we'd rather invest for growth, at the same time showing improvement

And I think that's probably documented by the fact that we grew billings 31% and headcount only grew 12%, which is over 2 to 1 in terms of a productivity measure there.

That's helpful. Great quarter. Thank you.

Thank you. Our next question or comment is from Sterling Auty of JPMorgan. Your line is open.

Yes, thanks. A couple of questions, guys. First, on linearity, with the DSOs, can you just talk to-- was there any change in linearity? Or is the DSO also maybe affected by you're doing more of these larger, high-end deals?

The key-- first of all, I think the linearity actually this quarter was better. We don't give the exact numbers, but the linearity, both in terms of the billings of the revenues was actually better.

What will affect DSOs, as much as anything else, is deferred revenue increases. Because what happens there, as you increase billings and deferred revenues, that doesn't show up in your revenues for the quarter and yet it shows up in your receivables. So the biggest impact for us will be the-- will be how billings compares to revenue growth in the quarter and the extent that deferred revenues, the billings, I mean, which they did this quarter, increases faster than revenues, that puts pressure on us to manage DSOs. That's the biggest impact on us from an AR point of view or DSO point of view and as linearity this quarter was actually quite good.

And then on the subscription front, you mentioned more customers were willing to do longer-term subscriptions. Is there any sense of what the mix of the customers choosing to do more than one year or some sort of average duration, possibly, of the subscription?

I'm looking around at my crack finance group here and everyone's shaking their heads. So no, I don't think-- it may be something we can look at to figure out, but as of right now, we don't have it. But it is interesting. We are seeing-- it surprises me a little bit. We are seeing interest by many of the enterprise customers to, basically, lock it in and do it.

And, by the way, just so you understand, we bill up front and we collect up front. So this-- you won't see us with long-term AR for these things. And so we only include it in our billings if it's billable and collectable within our normal payment terms.

And the last question is for Ken Xie. You mentioned, I think, a data center win. I was wondering if you're seeing more of a trend where there's still a lot SONET around that's moving to Ethernet. Is there a lot more data center refresh that you think's playing into your sweet spot with the high end appliance?

Yes. We see the advantage using FortiASIC, which gives higher performance and low latency and, at the same time, high core density and low cost. That really speaks quite well for the high-speed data center environment. And so that's where the data center, the big enterprise and-- really see the benefit of this ASIC-based UTM, which we're the only security vendor to have our own ASIC-- to have our own ASIC system (inaudible).

That's where the data center, the service provider, the (inaudible)-based telecom company and also some other vertical markets we're starting to see is really seeing the huge advantage.

All right. Thank you.

Thank you. Our next question or comment is from Todd Raker of Deutsche Bank. Your line is open, sir.

Hey, guys. Nice quarter. If you look, Ken and Ken, at the market today, you mentioned that you're starting to see a little bit of an enterprise refresh cycle, moving from kind of point product firewalls to UTM. How would you characterize or quantify kind of market growth today versus when you guys came out six months ago? Do you think the market has picked up and accelerating here? Or is this all competitive market share gains?

So this is Ken Xie. Also maybe Ken Goldman is going to add some more.

What I see is there two kinds of growth, gradually convert old firewall into a UTM. We see some competitors, which they relabel the product with-- some old firewall to UTM, which still misses some UTM features like anti-virus or some other intrusion, but that gives the UTM faster growing and the firewall market seems decreasing faster, because, overall we call it a security appliance, which is including both firewall and UTM intrusion is not growing that fast. But UTM, particularly, grows much faster, because some companies just relabel their products from firewall intrusion into the UTM. But total revenue or shipment in the security appliance not growing much.

The other thing, really, after some large acquisitions, we see some competitors also kind of more shifting now or building the old project into the new UTM, try to integrate different products together, which we're not really seeing doing quite well in the space yet, because to redesign, totally different products and integrate them together is not an easy job.

So for us, really, we dedicated the last 10 years to build up the multiple featured ASIC chip to do that. We don't see some other competitor having a short cut, can go through this process faster.

So that, I see, the UTM definitely people more taking the UTM message and it seems to grow faster, but the firewalls are decrease faster. So, overall, still growing, but UTM clearly going to grow much, much faster.

Yes, I think-- Todd, thanks for the comments. I think the-- when we went out late last year, I think many industries were just coming off of a very, very tough, as you know, '08 and early '09 and I think people were still very, very conservative in their expectations for spending. And so I do think we're much more in a normalized spending environment. I think there's a pent-up demand where a lot of companies stopped spending unless they absolutely had to. And so now they're opening up the spigots, if you will.

I think a lot of companies are seeing much better cash flow, so, therefore, the ability for them to afford spending and capital is much higher. So I think, my idea, anyway, what you're seeing is indicative of the entire technology landscape in which many of the technology companies are seeing overall good demand because companies that stopped spending for a year to a year and a half are now seeing stability in their businesses and, therefore, are much more comfortable buying.

And I think you-- that's probably most evidenced in the whole telecom space, just driven by all the new mobility appliances that we see out there.

Okay, great. Thanks.

Thank you. Our next question or comment is from Jayson Noland of Robert Baird. Your line is open.

Yes, thank you. Congrats on the quarter, gentlemen. Ken, the guidance seems a bit conservative, I guess, given your momentum coming out of Q2.

I was hoping no one would ask that question.

Is it just prudent, given macro concerns in your Europe?

Yes, what I try to do or we try to do with guidance is take into account a variety of factors. And it is subjective. It's one of things where you take into account what you see internally, things that could go right, things that could go wrong and you try to come up with numbers that, overall take into account numbers you feel good about, if you will.

And so I don't want to necessarily call them conservative or aggressive or whatever, but I think that we looked at moving them up, and I think in all cases we moved up numbers nicely from where they were before and that's worked for us in terms of how we have run the Company and so I feel quite good about how we're putting expectations out there and then our ability to go out and, frankly, meet and, hopefully, beat them. That's the way we want to run the Company.

Okay. Thank you for that explanation.

A question on service provider. I guess why are you guys winning? And is there better or worse visibility in this particular vertical versus others?

This is Ken Xie. I think service providers they tend to be more technical, have a require for the reliability, for the speed and also make sure the systems fit into the telecom environment. So that's where the structure-- the architecture we have founded on the FortiASIC, the high reliability and also the [ICSA] and all these kind of facts fit quite well.

That gives us much more advantage compared to most others, because they're software-based. Now with (inaudible) vendor, they just load-- the software loads on a standard PC and server, which does not quite fit well in a big telecom environment. So that's where the purpose-built ASIC-based appliance has much more advantage compared with software loaded on PC and servers in the telecom.

I think the thing that's helped us is, again, and we win different accounts that sort of begets winning other accounts and we're gaining a lot of expertise. The other thing that's helped us as many of these are recurring revenues and so these aren't one-shot deals where you sell one quarter and then you stop. In many cases, you sell consistent quarter after quarter.

Having said that, I think, without saying too much, there is a number of accounts that we have our eyes on that I think can really expand further. So while we've made some progress, there's still, I think, a large opportunity out there that we haven't penetrated yet.

Okay, great. Last question from me, on headcount. I believe you added about 23 people in Q1 and 41 in Q2. Should we expect to see that same sort of pace in the second half of the year?

Yes. I think maybe even a little more. I mean, other areas I should say we added people was in support and so we are adding folks in support as we do increase our installed base significantly. So we have a number of people we are adding in sales and I see that globally. We are adding-- probably in support, we added a lot in Q2, maybe not quite as much in Q3.

Having said that, our goal, if we accomplish it, will be to add more people in Q3 in R&D than we added in Q2. So those would be the areas that I would see.

Then it's really, like I say, we sprinkle a few people here and there in other activities relative to those two or three key areas.

Also, we created a new team focused on the healthcare market. It's a huge market, about same size as the telecom market.

Okay. Thank you.

And that-- what Ken's referring to, that's a new area we're carving out, if you will, out of our US sales organization.

Thank you. Our next question or comment is from Erik Suppiger of Signal Hill. Your line is open.

Congratulations. First off, just in terms of the competitive landscape, there's a few more players coming to market with more application-centric firewall technologies. You've got the application control. Can you discuss what you're seeing in terms of that aspect of your appliance?

Yes, this is Ken Xie. I think in the Internet security space we've been seeing more and more applications come out quickly on to the Internet but old like legacy features like firewall VPN and other intrusions still not go away.

So that's where it's how to balance quickly response to the new application and at the same time take care of the old legacy features there and without slowing down the network, without increased management costs or deployment costs.

So we view a lot of new we call point application firewalls. It's just a subset of what we do in the UTM, because even you can take in a few new applications, but you still need to secure the traditional security features there. They cannot throw away the old traditional security features.

That's where the key is, how to integrate, how to make sure it keeps up to speed of the network growth. It's quite important.

But, as to say, for us, when they integrated the new application into the firewall, that's just the first step and then the next step is to also look on how to leverage the ASIC chip to gradually offload the CPU and then kind of what we can (inaudible) add a new feature and also run current features faster.

So that's the same process we go through in the last 10 years and we see the huge benefit and also the advantage of this architecture. So that, I see the overall.

I think security space is interesting. You always have something new come up and that's for all the vendors. We always try to respond to other new applications and new challenges.

Okay. Ken Goldman, you talked about more of your enterprise customers buying multi-year subscriptions. What kind of discount do they get? Is that a big motivator for getting them to buy multi-year?

No, the-- it's very modest. The primary reason we find they want to do it is to look in the price so they don't have increased down the road. And two, sometimes they can handle the amortization in a way that's favorable to them as to how much they capitalize versus how much they expense.

So it's as much as they know-- it's almost like a cost avoidance that they don't want to have an increase down the road, so they lock it in now. And they also can handle it, in many cases, better from how they capitalize it and, therefore, how they would amortize it, the expense, over time.

And is there any way of quantifying how much benefit your billings for this quarter from the multi-year subscriptions? I mean, you had some pretty good upside. Can we assume that a small portion or a large portion of that came from the multi-year subscriptions?

Well, you remember I went through the increase in deferred, short-term and long-term. Long-term went up a little faster than short-term if we look at it quarter-to-quarter. So you can see that-- I don't know if I can quantify the absolute dollars, but you can get some sense by looking the relative increase of long-term versus short-term and how that-- and so that will affect us a bit and that's one of the reasons why we take that into account when we provide revenue guidance, which sometimes may not be as fast as billings guidance, just because we are looking at the timing of that revenue in terms of when we can recognize it.

Okay. Then lastly, can you comment how the WiFi product, what kind of contribution or growth are you seeing out of the WiFi product, in particular?

WiFi is still relatively a small of SMB or low-end shipments yet. We see there it grows faster on the average growth, but we have a lot of room to improve there.

Very good. Thank you.

Thank you.

Thank you. Our next question is from Jonathan Ruykhaver of ThinkEquity. Your line is open.

Yes, hey, guys. Congratulations on the performance.

Thank you.

I have a followup question related to these application-layer firewall capabilities. I guess what Gartner is calling the next generation firewall. Is that developed and having any impact related to UTM? Do you see any customers electing to buy that type of a capability instead of a UTM product when you go to competitive situations?

I see-- it's-- different research firms have some different names for this application firewall. Also, in the past, a lot of people call it a NAC, a network access control box. So we do some enterprises starting to have concerns for their applications. That's why from time to time the enterprises still combine the firewall, the point solution, together with some UTM.

But there is quite some research we see, they all see the application firewall just a subset of UTM. So if you compare feature-to-feature compared to the performance and even with all the applications, the application firewall can't pass. That's where the UTM has much more features and much more better performance. And also we have certification in each single function area which they have certification.

So that's where we view the customer, the-- they also starting to realize the application-- probably just covering a few applications may not be enough. There's still a lot of other things they have to cover using like a UTM or a more-broad-feature solution there.

So that's where-- the feedback we got.

I guess, can you support today, out of the box, the number of applications that, let's say, some of the pure-plays in that market can support in high-throughput environments? Or do you need to do more work on your ASIC to get that processing horsepower in place?

We have more-- well, we can take (inaudible) applications compared with some other competitors, (inaudible) there, but the key is really is how to make sure what provide a total security to the customer. Because sometimes some applications also combine with some other network functions, also kind of like hurt a customer, their internal infrastructure.

So that's where if we can-- I think that we're happy to see any third party can do some testing on the applications the UTM can cover and also the performance, because we believe the additional processing power and also the architecture we have which tightly integrates all these multiple functions, is much better performance. Also it will cover-- and also much more certified compared to some single-function box.

Right. Okay, good enough. I guess just one final question. I know that targeting the large enterprise environment in North America has been a pretty big initiative of the Company, an important strategic initiative as well. I'm just kind of curious. Is there any way you can kind of quantify how effective your channel is at driving those opportunities? Are you seeing any kind of no-touch business from that channel or is it really a case of you going in and driving the deal and then getting it fulfilled through the channel?

Yes, I actually think it's still mostly -- which is okay, actually -- mostly the latter where we-- it's heavily sourced by us and fulfilled through the channel versus the other side of the world, the SMB, which is just the opposite.

So that's okay. That's our model and we take that into account and I think that a-- I still-- we look at the margins the channel makes vis-a-vis what we make and manage that accordingly.

So when you look at the channel, the leverage you're trying to achieve from an operational standpoint, is that more the SMB and the mid-market, just driving no-touch business?

Yes. I mean, clearly-- yes. I mean, that's clearly what they do. And then in the higher end, even through we fulfill through channel, we have very, very good account control where we win in high touch in terms of work with the accounts.

Jonathan, just one more add (inaudible). I think in today's network security market, there's just too many hype and too many smaller companies try to claim some features and other things. For us, we have been there for many years and we feel the customer needs to be more trust some third party, whether by the certification or by the testing or by some reference of big customers they do the big deployment.

Because if some vendor they claim they can provide some security which cannot pass certification, then that's a big concern to the customer. So that's where we feel the third-party certifications are very-- are actually very, very important to validate all the features, all the technology, each vendor can deploy.

Yes. Makes sense. Okay. Thanks a lot, guys. Congrats on the performance.

Okay. Thank you very much.

Thank you. (Operator Instructions). Our next question is from Rohit Chopra of Wedbush Securities. Your line is open.

Thanks very much. Guys, I was wondering if there's any way to quantify the number of deals that you're winning where you're actually displacing an incumbent. Is there any way to do that?

Well, I gave some examples where we did, but we don't physically track every one in terms of that. So I can't give you hard data on that. I gave you a few examples in my prepared comments, some examples. And I know I went through it fast and so to the extent that you want it, there'll be a transcript out or you can listen to it on the replay. But in terms of absolute numbers, I don't-- we don't really track that.

I think the other point I want to add is really so if you look at Fortinet's history in the last almost 10 years now, so over 99% of growth organically, so we are not trying to grow ourselves like most other companies, do acquisitions, do some other things and then change the product from one platform to another.

So that's why everything we grow is really from organic growth, from the product we build ourselves. So that's where we're different than some other vendors we see. They can change the label from firewall to UTM quick, but overall revenue growth really not quite there. Or some other, just by buying some company and then switch the platform.

So for us, we believe the architecture we have, we believe the advantage of multiple features integrated (inaudible) leverage ASIC and that's where even take a much longer time to build, to develop, but a long-term benefit is much better compared to some software just loaded on a PC and server. So that's what I see there.

And the customer also takes some time to gradually see the benefit of this-- the long-term direction we're doing. That's probably some feedback I got.

Right. And it was-- by the way, it was the examples that you provided which actually prompted the question. That's why I was asking if you're tracking that kind of data. Do you actually track win rates, Ken?

No. Not per se. What we do is we track who the competitor is and we do track some deals we lose, but it's more anecdotal, in terms of-- It's a good question and a fair question relative to win/loss ratios, but we don't yet have metrics on that. It's a little hard in this business, because we certainly know the deals we're involved in.

I still-- I've said this many times, I still don't think we're getting involved in many, many deals because of either our sales coverage or our notoriety or whatever. It's improving, but we have a long way to go there. So I don't-- we don't really have a hard metric on that.

Okay. And last question is did you have to discount anything in Europe to offset the currency depreciation there? And could the margins have actually been higher?

Hard to tell, honestly. I mean, I don't-- nothing came to me that says, because of-- as many people know, we do bill in dollars, which I actually think Check Point does the exact same thing, as it turns out. But the-- so I don't see that as being an issue, as yet. At least, I haven't seen any messages that we had to do X, Y, Z because they were worried about the currency.

So we discount in varied situations to be competitive and sometimes, many times, to fit in the budget of the customer, but I certainly didn't-- it's interesting. I didn't see anything come to me, anyway, in terms of requesting a discount approval above the normal range that was FX-related. So that didn't come to me.

Thanks, Ken.

Thank you. Ladies and gentlemen, thank you for your participation in today's conference. This does conclude the program. You may now disconnect and have a wonderful day.