Fortinet Inc (FTNT) 2010 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Fortinet Q3 '10 earnings announcement call.

At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session with instructions following at that time. (Operator Instructions) As a reminder, this conference call is being recorded.

And now, your host for today's conference, Ken Goldman. Please begin, sir.

Great, and good afternoon. Thank you for joining us on this conference call to discuss Fortinet's financial and operating results for the third quarter of 2010.

Joining me on this call are Ken Xie, Founder, President and CEO of Fortinet, and Michelle Spolver, Vice President of Corporate Communications.

In terms of 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'll then conclude with some thoughts on our outlook for the fourth quarter 2010 and full-year 2011 before we open up the call for questions.

30 p.m. Pacific time and will also be webcast from our investor relations website and accessible as detailed in our earnings release.

Before I begin, let me just read this disclaimer. Please note, some of our comments we make today are forward-looking statements, including those regarding our financial guidance for the fourth quarter and full-year 2010 and full-year 2011, the momentum of business, our ability to execute and drive growth in coming quarters, the adoption of UTM solutions across sectors and geographies, and trends in network security consolidation, the portion of our business derived from large customers, investments and expected leverage from our sales and R&D infrastructure.

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

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

Also, please note, we will be 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.

//investors.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 our website. Please note that we routinely post important information on our investor relations website, and we encourage you to make use of that resource. And I promise I won't go that fast for the rest of this.

3Q 2010 financial results. Let me start by providing some of the highlights of Fortinet's third quarter 2010, which were well above our expectations from a billings, revenue, profitability, and cash flow perspective.

First, summarizing some of the key numbers, as you can see on slide two. Billings increased 33% to $94.7 million year-over-year, revenues grew 29% to $85 million year-over-year, and our product revenues grew 41% to $35.9 million. Non-GAAP operating margins were 24%, non-GAAP EPS was $0.17, and free cash flow was $31.5 million.

This is the fourth consecutive quarter that Fortinet has reported strong and better than expected results as a public company. We are most pleased by the tremendous progress we made in all the forward-looking growth drivers, including billings, product revenues and cash flows.

First, we saw a significant increase in billings and are particularly pleased with the balanced growth across all by geographic regions. Second, product revenue, which we view as a leading indicator for our recurring services business, grew over 40% year-over-year. Finally, the combination of our solid 3Q results, in addition to improved working capital efficiency, led to the 116% year-over-year increase of free cash flow.

From a high-level perspective, I can now discuss the primary drivers to Fortinet's strong performance over the last year, including the third quarter. First, we have seen some improvement in the overall economic climate. Second, we believe that there has been improvement in the IT spending environment, and within that we believe that security is one of the top priorities among overall technology spending. This view is supported by industry and sector analysis as well.

For example, a recent CIO survey conducted by a top financial institution showed that 80% of CIOs expect increased security spending in 2011, up from 70% in 2010. Within this segment, network security showed the sharpest increase with 74% of CIOs looking to increase spending, compared to 60% for 2010.

The growing importance of IT security is one of the reasons that Fortinet was able to continue growing throughout the economic downturn, and industry data suggests the security market in which we play--and we'll be a beneficiary as the economic environment in IT spending improve.

Third, we believe that Fortinet is continuing to gain market share through our industry-leading technology and continued product innovations. The growing recognition of our price-performance advantage in the market combined with the recent introduction of new products, such as our FortiGate-3950B, FortiGate-1240B and FortiGate-60C are playing an important role in our competitive success.

Fourth, we are gaining traction with the higher-end product segments, due in part to investments we made over the past year to build out our sales organization and sharpen our focus in this area. This is evidenced by the growth in the high-end percentage of billings in addition to the increase in deals over $100,000, $250,000 and $500,000, many of which were UTM deployments.

As pleased as we are with the Company's momentum and strength of our third quarter, it is worth highlighting a few key points to keep the third quarter's strong performance in perspective. Most significantly, we have several large enterprise deals in the third quarter, including a multi-million dollar UTM deployment. While these deals demonstrate the traction we are getting with large enterprises, we are not expecting deals this size to reoccur every quarter.

Expenses were also lighter than expected this quarter, which can be seen by a sequential decline on non-GAAP operating expenses. While this was due in part to cost-containment initiatives, it was also related to slow than anticipated hiring, seasonally high use of PTO, vacation, and a favorable currency impact, which I'll discuss in more detail later.

Consistent with our long-term strategy, we do remain committed to investing in our growth, and we'll look to continue to expand our sales force and R&D for the balance of this year and into 2011.

In summary, we had an exceptional quarter. We are pleased with the Company's execution and feel good about our momentum and market position. I will talk about our guidance, both in terms of Q4 '10 and '11, after Ken has--goes through his remarks.

So, let me now go through some detail. In terms of the income statement, you can see this on slide two. Billings were $94.7 million, an increase of $24 million, up 33% compared to the same period last year, and up 5% from Q2, and well above our guidance of $87 million to $89 million.

We achieved balance growth in billings across all three geographic regions, as it compared to Q2 2010. If you look at growth year-over-year, the growth by region was Americas up about 31%, EMEA 34% and APAC 35%. So, again, you can see very consistent across our three geographic regions.

As you can see from our product segmentation on slide three, we are maintaining our momentum in executing high-end deals, as they accounted for 39% of product billings compared to 29% last year. This increase reflects the traction we are gaining in new products that have been introduced over the last six to 12 months in the high-end segment.

In terms of verticals contributing to the growth in high-end, the telco space was one of the strongest sectors for us in 3Q, driven by the increased trend to have service providers delivering security as managed services.

Additionally, as stated in prior calls and presentations, growing our position in the enterprise segment sector has been a priority for us, and I'm pleased to report we are continuing to succeed here as evidenced by the growing number of large deals in Q3. The number of deals over $100,000 for 3Q was 101, and that compares to 67 in last year's Q3. For $250,000, the number of deals was 38 versus 21 last year. And the number of deals over $500,000 was 13 versus--compared to 8 in last year's quarter. We also had a number of deals over $1 million.

I would like to take a moment to discuss a marquee enterprise deal that closed in Q3, which was with a US-based Global Fortune 100 food company. This multi-million dollar net new win was our largest deal during the quarter, and also the largest in our history. It represented the first of a three-phase deployment. It was a particularly notable win based on the global scope and breadth of our products deployed, including numerous FortiGate, FortiWifi, FortiManager, and FortiAnalyzer appliances, as well as our FortiClient endpoint software that will be deployed to every desktop companywide.

This customer wanted to reduce network security complexity and cost. Fortinet was chosen due to the strength and breadth of our UTM solutions, along with our ability to provide a true end-to-end solution that could be centrally managed and reported. We beat out Check Point and Cisco for this year.

In terms of revenue, our total revenue was $85 million in the third quarter, which is up 29% on a year-over-year basis and well exceeds the high-end of our guidance of $75 million to $77 million.

As I mentioned, we benefited from several large multi-million dollar deals during the quarter, which contributed to our higher product content--the billings there is typical. The mix of new and gainers compared to renewals, and the mix of products to services within deals, contributed to higher product revenue as well as our ability to fully ship products during the quarter. Going forward, we don't expect to necessarily see the same mix with regards to our in-quarter billings.

Taking a closer look at revenue, there were a number of verticals that contributed to the strength in Q3, and I'd like to highlight some of these key wins. We continue to gain traction in retail. An example is a win with a US-based multi-billion dollar power company with approximately 775 retail locations worldwide. This customer wanted to secure and connect its retail stores and branch sites with a feature-rich integrated security solution that was flexible and met PCI standards. We displaced SonicWALL Frisbee, which included our recently announced FortiGate-60C and FortiGate-1240 appliances.

We also maintained our growth in financial services and have continued to win deals based on superior performance in security. Two key Q3 wins in the financial services vertical include a win in the US with a large electronic trading platform that connects more than 70 global banks through an electronic trading network. Similar to other financial services wins which we mentioned last quarter, we won this deal through our superior price performance and low-latency firewall advantage, beating out Juniper and Cisco.

Another example was a win in EMEA with the largest Pan-European equity trading exchange. We won over Juniper, Cisco and Check Point due to our low-latency firewall performance.

Additionally, we continue to see strong momentum in service provider business worldwide, as providers look to delivery--to deliver security as a managed service to their customers, as well as to secure their own networks.

Some notable wins included a large deal with a global communication networking service provider in Asia seeking a UTM security platform by which they could soon be rolling out cloud-based managed security services. We won against incumbent Juniper and sold in our high-end FortiGate, FortiManager and FortiAnalyzer appliances.

Another win was with one of our only--was with one of only six Tier-1 internet providers in the world. This customer wanted to rollout CP and cloud-based UTM managed security services and sought a vendor who could support both delivery models and also support virtual domains in very high-performance requirements. Fortinet again displaced the incumbent due to our superior performance, virtualization capabilities and breadth of product portfolio.

Looking at slides four and five of the presentation, you can see that Fortinet continues to be highly diverse from a geographic perspective, and all the geographic regions outperformed our expectations, and we continue to leverage our investment in our sales infrastructure and build brand awareness on a global scale.

As a reminder, the geographic split of revenue is calculated using the bill-to address. So, in terms of the Americas, we recognized $35.4 million, compared to $26.1 million the prior year, increasing 36%. The Americas was particularly benefited from some large enterprise and service provider deals in the quarter, some of which I mentioned earlier.

In addition, from the seasonality perspective and consistent with last year, revenues in the Americas were strong in 3Q as we have not experienced the same seasonal slowdown in the Americas as we typically see in Europe through the summer months.

We also experienced good growth in Latin America. In terms of EMEA, we had $28.9 million, versus $23.5 million the prior year, representing an increase of 23%. We experienced the continuation of demand in Europe with a good momentum in the MSSP space and among enterprises. We also--I would add that we experienced our normal seasonality, which EMEA does decrease from Q3 compared to Q2. Infrastructure products and virtualization were also drivers of service provider and enterprise traction.

Additionally, we won a number of telecommunication service provider deals based on our high-performance UTM solutions, including the recently announced FortiGate-3950B. Also, we closed some key financial services deals in the UK, France and Germany due to our low-latency firewall advantage.

In Asia-Pacific, we achieved $20.7 million versus $16.3 million the prior year, increasing 26%. Year-over-year growth improved compared to Q2 2010 with revenues, again, well dispersed across the region.

We experienced traction with MSSPs and service providers, particularly in Singapore and Hong Kong, and won enterprise deals with the companies who were looking to upgrade their security infrastructure, with focus on Web content filtering IPS. Performance was strong in Japan, Malaysia and the Philippines.

Now, looking at product revenue. We reported $35.9 million during the quarter, which represents an increase of 41% on a year-over-year basis and up 16% from the second quarter of 2010. You can see slide six for the revenue breakdown between products and services.

As I mentioned, we view product revenues as an important leading indicator, and therefore the strong growth bodes well for our services business in the coming quarters.

Q3 2010 was by far our best yearly shipment volume quarter ever. We experienced growth across all product segments. A shift in mix to a high-end of product families and to higher-end products within product families contributed to an increase in overall ASPs. As mentioned earlier, product revenue benefited in the quarter due to a number of large deals with higher product content and a better mix of higher-end products.

Services revenues in the quarter were $44.5 million, up 21% compared to $36.7 in the year ago quarter. As mentioned last quarter, we continue to see a positive trend in longer-term deals as we execute on our strategy to focus on the larger enterprises. This trend has continued--has led to the improved visibility in our business.

Large customer wins are more inclined to sign up for longer service fields, along with their securities. It also does affect, however--as you can see in near-term revenue realizability. We expect the services revenues to increase over time due to our deferred revenue model and our growing installed base of security platforms.

Our renewal rates have continued to improve, reaching 70%-plus range for our service offerings at the end of the quarter. This was by far our best quarter. The improvement in renewals is being driven by improved systems and reporting result in reporting, which is all even better for our carrying from our renewals sales team. This has resulted in improved rates across the board.

We continue to focus on bundles. In many instances, we have found customers prefer to purchase three-year bundles with the expectation that they will buy the next generation product after the three-year period.

Finally, our ratable product and service revenue was $4.5 million, an increase of $0.9 million or 26% on a year-over-year basis.

Revenue (inaudible) a couple metrics. DSOs was 63 days, compared to 60 the prior year or slightly below the low-end of our target of 65 to 70 days, and were down sequentially 71 days last quarter due to improved linearity and good collections. We continue to witness excellent AR aging and credit quality.

Deferred revenue balance decreased to $235.3 million, up $44.9 million or 24% year-over-year and $9.7 million or 4% versus the second quarter. And we had no changes in our accounting treatments.

We increased headcount slightly. We ended the quarter with 1,300 employees, compared to 1,287 in Q2 and 1,196 in 3Q of last year.

As I mentioned earlier, our pace of hiring was slower than originally targeted for the quarter as it was a challenge to hire qualified sales and technical staff as quickly as we had anticipated, due in part to seasonality, competitive landscape and the degree of specialized security expertise required.

As you can see on slide seven, Fortinet is a globally diversified business. We continue to invest and add headcount worldwide. Approximately 77% of our headcount is located outside of the US, which provides us a nice balance.

Functionally, sales and marketing and R&D account for approximately one-third each and are well balanced across three main geographies. Services and support accounts for approximately 21%, with G&A at 8% and operations at 3%.

Given all this, we achieved significant operating leverage as we grew our billings by 33% and our revenues by 29% year-over-year, compared to a 9% year-over-year increase in employee headcount. As a result, we reported a non-GAAP operating margin of 24%.

As I mentioned earlier, we had several very large enterprise and service provider deals in the third quarter and don't necessarily expect this type of deal flow to be characteristic of a typical quarter in the near term.

Also, 3Q was seasonally stronger, similar to last year, and expenses were lighter due to slower than anticipated hiring and favorable currency impact.

On slide eight, you can see our annualized revenue per employee increased to another record of $263,000 in the third quarter, which is up from $241,000 in the second quarter of 2010 and $225,000 in the third quarter last year.

In terms of income statement cost ratios, our total non-GAAP gross margin was 75% in Q3, compared to 74% in Q3 '09 and slightly above our targeted range of 71% to 74%.

Non-GAAP product gross margin was 63%, compared to 59% in Q3 of last year. Sales of our high-end products positively impacted product margins, and discounting was held in check.

Non-GAAP service margins--service gross margin, I should say, of 86% during the quarter was flat with the prior year. We do expect non-GAAP gross margins to revert to our target range.

Total non-GAAP operating expenses were $43.2 million in Q3, up 17% year-over-year, but down 3% sequentially. In terms of revenues, total non-GAAP operating expenses during Q3 were 51%, which compares to 56% for the same period last year and 58% during the second quarter of 2010.

Non-GAAP R&D expense increased 14% year-over-year to $11.8 million. As a percentage of revenues, that was 14%, which compares to 16% for our Q3 of last year and Q2 of this year.

Non-GAAP sales and marketing expense similarly increased 14% year-over-year to $26 million, and as a percentage of revenues, marketing expenses--sales and marketing expenses were 31%, compared to 34% last year.

While a decrease in sales and marketing as a percent of revenues illustrates the leverage we are achieving through investment in the sales force, we also do not hire as quickly as we anticipated. And non-GAAP G&A expense increased 35% year-over-year to $5.4 million. As a percentage of revenues, basically, non-GAAP G&A was flat at 60% of revenues.

Finally, expenses were also lower due to favorable currencies. The dollar was relatively strong in Q3. This was most evident in Europe and Canada where we have significant headcount in sales and R&D respectively. However, given a near 10% depreciation in the dollar against our core currencies, we do expect this to increase commensurably in those areas.

In terms of profitability, non-GAAP operating income was $20.6 million and represented a non-GAAP operating margin of 24%, compared to $11.7 million and 18% of operating margin last year and 16% of operating margin in the second quarter of 2010. Our operating margin far exceeded our guidance due to both revenue growth and expenses coming in below expectations.

Other income decreased $0.3 million in 3Q compared to the same period last year due to some modest FX losses.

Pro forma tax rate for non-GAAP results in the quarter was 35%, compared to 24% in the prior year. Based on the annual estimate for geographic split of income, as well as various tax credits we expect to achieve in various locations, Fortinet expects a 35% tax rate for the year.

The primary difference between the lower GAAP rate with pro forma rate is associated with adjustments in the terms of pricing as it relates to stock options associated with some of our foreign subsidiaries.

Non-GAAP net income was $13.5 million in 3Q, compared to $9.2 million in the third quarter of 2009. Non-GAAP diluted earnings per share was $0.17. This exceeded our guidance range of $0.09 to $0.11 and compares to $0.14 in the third quarter of 2009.

Comparing to last year considerations include diluted shares outstanding were 77.9 million, compared to 64.2 the prior year. This growth of a 13.7 million increase in weighted shares outstanding primarily linked to shares issued in IPO, exercising of stock options and a 3.8 million increase in the calculation of diluted options due to the higher market value of Fortinet stock. And our pro forma tax rate, as I noted, was 35% versus 24% last year.

There's a full reconciliation between non-GAAP and GAAP results in our earnings press release and slides 12 and 13 of the presentation accompanying today's prepared remarks, and for those non-GAAP financial measures that are not described in the earnings press release.

Let me quickly go through, just quickly, a summary of GAAP numbers for 3Q. GAAP net income was $14 million in the third quarter, compared to $7.9 million in the third quarter of 2009. It's important to note that our GAAP tax expense was 23% of pretax income. As a result, it brings the year-to-date effective tax rate to 29%.

The primary difference between the GAAP rate and the pro forma rate of 35% is associated with adjustments in our terms of pricing as it relates to stock options associated with some of our foreign subsidiaries.

GAAP results in 3Q include $2.4 million stock-based compensation expense and approximately $4,000 in company cumulative tax expense from the exercise of stock options.

So, let me now move to cash--balance sheet and cash flow before Ken will be speaking. So, you can see the balance sheet and cash flow highlights on slides nine, 10 and 11. In terms of--let me just summarize a couple. Cash is an important metric in gauging our business. We ended the quarter with $352 million in cash, cash equivalents and short and long-term investments or over $4.50 per fully-diluted share. Note that this includes cash under the long-term investments category.

The $43 million increase in Q2 was primarily due to cash generated from operations, in addition to the exercising of stock options during the quarter. Cash generated from operations was $32 million in 3Q, our 18th consecutive quarter generating positive cash from operations, excluding some one-time items.

Cash flow from operations is primarily the sum of non-GAAP operating income plus depreciation, net change in deferred revenues, accounts receivable and accounts payables.

In the third quarter, free cash flow also was approximately $32 million, up 116% versus 3Q '09. Through the first nine months of 2010, we have generated $69 million of free cash flow. That's a 67% increase over the first nine months of 2009.

Free cash flow was positively impacted by $1.4 million during the quarter by a non-recurring item related to gains realized from stock option exercises received, but not yet remitted, to employees who work at our foreign locations.

Other balance sheet highlights, A, our balance sheet remained flat at $59.6 million. This compares to Q2 of 2010. We achieved strong collections for the quarter of $93.8 million. DSOs were down 63 days from 71 days in Q2 due to improved linearity, and aging continues to be current.

Inventory has decreased to $11.3 million from $12.1 million in Q2. The decrease in inventory was due to the higher than expected billings in the quarter and tight controls over production. And the inventory turns were 3.9 in this quarter compared to 4 last quarter--last year's quarter. Net PP&E remains stable at $6.8 million compared to Q2.

Deferred revenue balance increased to $235.3 million, up 24% year-over-year and 4% sequentially. Short-term deferred revenue increased to $158.4 million, up 19% year-over-year and $4.1 million or 3% versus Q2. Long-term deferred revenue continued to grow faster. The increase was $76.8 million, up 34% year-over-year and $5.6 million or 8% over Q2. And as noted, we ended the quarter with $352.3 million in cash and long--short and long-term investments.

So, in summary, we reported a solid quarter and exceeded our expectations across all of our key operating metrics. A strong billings and product revenue growth highlighted the solid execution of our global go-to-market strategy. We experienced robust demand within the overall UTM market in addition to achieving additional market share gains. The non-GAAP operating margin of 24% came in well above our expectations and operating model.

We are excited about the ongoing leverage we are seeing in the business. Again, while it was partially due to our focus on expense management, it also reflected a slower than anticipated pace in hiring and a favorable currency impact, two factors that we would not expect to benefit margins next quarter.

Finally, substantial cash generation continues to reflect our focus on working capital management, excellent collections and a solid underlying operations.

I would now like to turn the call over to our CEO, Ken, who will provide some thoughts on the overall security market and discuss some of the third quarter accomplishments and new developments on the product innovation side. I will then come back to provide 4Q guidance and our early thoughts as it relates to 2011.

So, with that, here's Ken.

Thank you, Ken. And thank you to everyone who joined us on the call.

As Ken shared, Q3 was exceptional all around. We meet or exceed all key financial metrics. I'm pleased to say we are executing quite well as a Company and growing market share and gaining customers across all segments.

Before covering some of these areas in detail, let's--let me first highlight some market trends that are driving our business. First, the growing shift to managed security service delivery with service providers using Fortinet appliances as a platform to deliver a degree of cloud and customer promise-based managed security service. Today, we count 10 of the top 10 telecommunication companies as a customer.

Second, the enterprises are increasingly adopting the consolidated UTM security appliances. We increased our focus on the enterprise area and also leading us to gain in a market share in this area.

Third is the growing need for high-performance security solutions to meet increased network speed and secure most bandwidth demanding applications.

Our FortiGate (inaudible) us to offer unmatched performance, which is one of the major competitive advantages and differentiators of us winning in the market.

Speaking of wins, as Ken mentioned, we won several key deals with service providers around the world and made significant progress in the enterprise sector, particularly in the US, where we won the largest deal in our history with a Global Fortune 100 enterprise.

Additionally, we experienced good traction in the adoption of our recently announced new product, especially the FortiGate-3950B and the 3951B where we won several provider and enterprise deals during Q3.

So, one of these deals was a large telco company in Europe who's using our FortiGate-3950B product to secure its internal 3G network. So, we won this deal against Juniper based on our ability to deliver unmatched performance.

Our other win is a leading mobile communications service provider in APAC, who protect its GPRS mobile network with FortiGate-3950B along with other FortiGate--Fortinet products. Our superior [10G] price performance drive this win against Juniper and Check Point.

We also made traction with our FortiAP, the Wi-Fi access point solution. Among the deals we won in Q3 included one with a large US retail enterprise who are using the FortiAP to provide secure wireless for more than 100 retail stores across the country.

On the innovation front, we recently announced and began shipping a new product that strengthens our product portfolios and differentiates us in the market, including the FortiGate, FortiManager, FortiMail, FortiAnalyzer virtual clients, which extend our ability to offer managed service providers and enterprise with security unmatched for virtualized and cloud environments.

Fortinet has been securing virtual architecture since the introduction of our virtual domain technology in 2004. And then, we strengthened our virtualization capability in 2006 with the acquisition of the intellectual property and technology from CoSine Communications, one of the early leaders in the virtual appliance industry.

(inaudible) is a totally new Fortinet application firewall appliance, the FortiWeb-1000C for the enterprise and the FortiWeb-3000C for the service provider. The FortiWeb products are well suited for the retail and healthcare organizations that require maximum protection for the Web application content-sensitive data subject to the PCI and the HIPAA guidelines.

We also introduced FortiGate-3040B and began shipping the FortiGate-3950B in Q3, both of which are--both of these FortiGate-3000 series raised the bar on price performance, especially the FortiGate-3950B is one of the finest firewall UTM products on the market. It delivers highly connective throughput with exceptional low-latency. This new FortiGate-3000 series well fit the increasing requirement of the enterprise and the data center security market.

Fortinet's innovation and customer adoption also continues to yield the market share leadership and the share gain. As you can see in slide 14 of the slide, the IDC most recent UTM security market tracker for Q2 2010 shows Fortinet was the only major security vendor to gain in UTM market share, growing from a market share of 14.7% in Q1 to 16.4% in Q2 quarter-over-quarter. So, this is compared to all the other seven major UTM vendors who are all losing some market share and who also each hold less than 10% of total UTM market share.

And finally, our products continue to receive applause in the market. Early this week, we was announced--it is announced that--it's a--2010 Reader's Choice award in the Information Security Magazine. They gave our FortiGate-1240 the Gold award for the best network firewall. And also, our FortiScan won the Consumer award for the best vulnerability management solution.

So, in closing, the trend towards network security product consolidated into the UTM is increasing across all sectors and regions, making it more secure, lowering cost and easier to manage. As the pioneer and market leader, Fortinet is well positioned to continue to win.

So, now let me turn the call back to Ken Goldman, who will give the discussion of our financial outlook in Q4.

Yes, thanks. And, sorry, I probably covered a little more than you all wanted to hear. But, let me finish it off and talk about the guidance that does include forward-looking statements, and do keep in mind my earlier comments.

I will begin with an outlook for the fourth quarter. We feel good about the Company's momentum following our strong performance this past quarter. With that said, a portion of the upside during the quarter was driven by factors that we don't expect to reoccur in the fourth quarter, and some of which may reverse.

Therefore, there are a few key points to keep in mind that will put the third quarter overall performance in perspective, particularly as it relates to modeling our business moving forward.

First, we had several enterprise deals in the third quarter. We would not necessarily expect this type and size of deal flow to occur every quarter.

Second, from a seasonality perspective, we did not see a slowdown in the Americas like we typically see in Europe through the summer months. This is consistent with the same seasonality last year, where 3Q was particularly strong in the Americas with growth tapering off a bit in the fourth quarter.

In fact, last year, revenues in the Americas decreased from Q3 to Q4, and non-GAAP operating margins declined to approximately two points from Q3 to Q4, and we picked up the pace in investments in sales and marketing to support forward growth.

Finally, from an expense standpoint, we expect expenses to ramp up due to increased investments in sales and R&D to support our 2011 growth expectations and combined with the fact that currency is expected to go from having a favorable impact to a headwind in the fourth quarter. We estimate that currency could easily add $1 million more to expenses in Q4 as compared to Q3.

Taking into account the factors I just mentioned, we are suggesting the following guidance for the fourth quarter, which can be seen in slide 15. The billings estimate, $100 million to $105 million, which at the midpoint represents year-over-year growth of approximately 25%.

Total revenue estimated range of $85 million to $87 million, which is at midpoint represents year-over-year growth of approximately 22%. Note that we expect the greater percentage of billings in Q4 to be annual service contract renewals vis-a-vis the overall mix that we saw in Q3.

Gross margin of approximately 73% to 74%, which is still at the high end of our model. Non-GAAP operating margin range of 18% to 20%. This is consistent, by the way, with our longer-term model and what we saw last year and consistent with the fact that some of our intended investments in sales and marketing and R&D moved from the third quarter to the fourth quarter. Even with these increased investments, we are targeting a higher fourth quarter operating margin than our guidance implied at this time of last call.

Non-GAAP earnings per share expected to be in the range of $0.13 to $0.14 based on expected diluted share count of approximately 80 million.

Thus based on the fourth quarter guidance and the stronger than expected performance of the third quarter, we have raised our full-year 2010 guidance as follows. Billings to be in the range of $364 million to $369 million, which at midpoint puts us at approximately 30% growth for the year. Total revenue will be in the range of $316 million to $318 million, which at the midpoint represents year-over-year growth of approximately 26%. This is up from previous guidance of 20% growth. Gross margin will be approximately 74% and operating margin to be approximately 18% for the year.

The midpoint of the fourth quarter non-GAAP operating profit range results in $56 million to $58 million annual operating income, and--which is year-over-year growth of 62% and demonstrates the leverage in our business model.

Our EPS is expected in the range of $0.49 to $0.50 based on an annual expected diluted share count of approximately 77 million.

And taking into account--finally, taking into account the overachievement of free cash flow in Q3, we now expect free cash flow for Q4 to be in the range of $15 million to $17 million. This brings free cash flow for the year to be approximately $85 million, an increase of 47% year-over-year and up from our previous range of $68 million to $70 million.

While we've been fortunate to outperform relative guidance to the public company thus far, it is--you know, I always remind you all to--for you not to get ahead of us, particularly as we start to look ahead to next fiscal year.

As it relates to 2011, we will not have completed our budget process for another couple of months, but I will provide some initial thoughts, so if that's the case, it be kept in proper perspective between now and our next earnings call.

To start, I would reiterate to be mindful that there's still a level of uncertainty regarding the pace of economic recovery. The data points in the economy are conflicting, and in any quarter there are a range of factors that can be pluses or minuses. As such, we believe it is appropriate to maintain that cautiously confident stance and to plan our business in a prudent manner.

From a revenue growth perspective, taking into account the fact that anticipated revenue in 2010 is well above our original and even readjusted plan, thereby creating a more difficult comparison, we believe we can achieve growth in the range of the mid to upper-teens for the full-year 2011. This will be above the expected market growth.

From a profitability perspective, and our operating margins well exceeding our initial expectations for the year, we believe we can achieve non-GAAP operating margins next year that are comparable to 2010, which is consistent with our longer-term model of 18% to 20%. And again, this assumes we achieve our revenue targets.

We still have work to do regarding expense levels for 2011, and our goal is to ramp up investments in sales and R&D as I said before.

In regards to free cash flow for 2011, my sense is it's still too early to project given the range--the larger range of variables--the range and number of variables, including when and how much we'll pay for tax. So, we'll hold off on any guidance there until our next earnings call.

So, in closing, our third quarter was solid across the board. We will continue to focus on executing our growth strategy and increasing our market visibility through the same strategy we've been executing for the last four quarters, which is leveraging our price performance as an advantage to win new customers, as well as securing additional deployments with existing partners, strengthening our sales to support coverage, a critical element in our efforts to penetrate large enterprise, and expanding the breadth and capabilities of our solutions through continued product innovation.

So, I'd like to thank our employees worldwide for their hard work, customers for choosing their product with Fortinet and our shareholders for their continued support.

So, with that, let me turn it to the operator for our Q&A.

Thank you. (Operator Instructions)

Our first question is from Jonathan Ruykhaver of ThinkEquity. Your line is open.

Yes, good afternoon. Congratulations on the performance, guys. Very, very impressive.

The question--first question is to what extent has the extension of terms to multi-year periods for maintenance and subscription impacted the billings performance in the quarter?

Yes, your question is how is it impacting. It's a hard one to say.

I mean, I think you can see that a little bit in the increase in deferred--long-term deferred revenue, which I went through a little earlier. So, it's affecting it a little bit, but I don't think it's that substantial. I mean, it's certainly very consistent with where our approach has been, and what, frankly, customers have wanted. And that's--they want certainty of expense. And so, that's why we're seeing a great tendency to do multi-year bundles, which, again, is taken into account.

Now, having said all that, we did have a great product revenue component, and you see that with the higher revenue we had in growth of our product revenue year-over-year. So, that was sort of all, basically, taken into account.

Do you think it's a couple points in terms of the contribution to the billings growth?

That's probably the range, without having the exact data in front of me. So, that's--I mean, I don't think it's much more--I don't think it's more than that.

Okay. Okay, good enough.

And the second question. Can you talk a little bit more about the virtual appliances that were recently introduced? Specifically, where do you see the bigger opportunity near-term? Is it more related to cloud services and service providers or do you also see a demand within the enterprise who want virtual infrastructure?

This is Ken. I feel the virtual appliances more fit into the service provider, which they are using the--our virtual technology since 2004, and also the bigger data center.

The large enterprise also sees some early trial adoption of the virtual appliance, but it's still the majority come from the service provider, and also the bigger data center.

Okay.

Have you been shipping that product yet or is that expected to happen this quarter?

We just announced early this quarter. We're starting to do a few trials in some shipments right now.

Okay. Okay, good enough.

And then, also, on some new products, the 3950 and the 3951 appliances, could you talk about the application control features on those products? And how important is that as a feature in the marketplace?

I think the key advantage for 3950 is the high performance with a very, very low latency, all this network performance with the firewall, the VPN intrusion, all these things. That's what the enterprise and service providers needed.

The application control is just one of the top features, which is mostly the access control layer. But, the main customer buying the 3950 is more because the high performance across all these multiple features from our firewall intrusion, antivirus and including the application control.

But, we do have much more features than the application control. It's just one small set of the feature we have.

Okay. Okay, understood.

And one last question of Ken Goldman. On 2011, you talked about overall numbers on the top line. And I'm just kind of curious, how should we think of the March quarter in terms of seasonal trends from a revenue perspective?

I don't have any--this kind of detail. What I'm just--what I'm trying to do is give--is--the key to me is not letting you folks get ahead of us in terms of changing the numbers. And so, if you're saying you want to keep the numbers where they are, that's all the better to me.

And, I mean, I don't have detail as to quarter by quarter to suggest anything different on any quarter, given the overall guidance I gave.

Okay.

But, in terms of product revenues, we probably should expect to see a sequential decline in the March quarter, similar to what we saw last year?

That's probably true, without having all the data in front of me.

Okay. Okay, good enough.

Thanks, guys, and congratulations.

Thank you.

Thank you.

Thank you.

Our next question is from Keith Weiss of Morgan Stanley. Your line is open, sir.

Excellent. Thank you, guys. This is Keith Weiss on for Adam Holt.

I was wondering if you could talk to us a little bit about the hiring situation and your ability to, sort of, hire the guys that you need to hit your plan. Have things gotten better? I was wondering if you could give us some color into the hiring to date.

And as a follow-on, is this at all impacting your sales capacity and your ability to sustain these types of growth levels?

Yes, I actually don't think the--I think it's like anything else. I think if we hire more sales people, in theory you can sell more.

I don't necessarily think it's--I certainly don't think it constricted our ability to sell in Q3. I do feel it's--it will be quite important for our growth in '11 to balance hiring with the fact that we do believe that we continue to gain efficiencies in the way we scale. So, we are balancing all that.

But, for us to grow at even better rates than we may be projecting, it's going to require hiring sales. And then, in the R&D area, I think that's an area that--you know, we are fundamentally a products-driven company. We do see a phenomenal uptake of the new products when we introduce them. And so, key to our growth going forward is our--will be our continued ability to bring out new products and get them into the market.

So, I think--I wouldn't say hiring was a constraint this past quarter. But, on the other hand, it could be a constraint going forward in terms of what our expectations are.

Got it.

And can you talk to us a little bit about some of the issues that you're having in hiring? Is it just not finding the right candidates? And, B, has that gotten any easier in 4Q or a month into the quarter? Have you been able to pick up the pace of hiring quarter-to-date?

Well, we've only just started the quarter. I'm not going to give you exact numbers. We've had a good start to Q4 in terms of hiring.

You know, I think part of it is going to be we're going to have to probably add some recruiting help to the equation, and, honestly, put a little bit more focus on it.

The other thing I would say is Q3 tends to not be an easy quarter to hire with a number of folks, particularly in Europe, on holiday. So, it's not totally unexpected that hiring might lag a little bit in Q3.

But, I would say on the margin with putting a greater focus on hiring as we go forward than we may have in the last couple of quarters.

Excellent.

And if I could sneak in one last one. I was wondering if you'd just tell us about federal business in the quarter, federal fiscal year end in Q3? How did you guys do with your federal business?

It was solid, actually. I mean, it was very close to what our expectations were for that sector.

Having said that, we have work to do with--we added a new head to that group about a quarter or so ago. We will continue to add some new folks as well to that group. And we continue to monitor the budgetary situation, which I also, sort of, see some conflicting signals on.

So, I would say, overall, we had a solid Q3, very close to our expectations. And that is one area that we're now looking to re--rebuild is the wrong way--to build up our sales headcount.

Excellent.

Very nice quarter, guys. Thank you very much.

Thank you.

Our next question is from Lauren Choi of JPMorgan. Your line is open.

Hey, guys. This is Lauren for Sterling Auty.

I think a number of your competitors have been kind of talking about their initial indication from their sales teams as they set up, kind of, for Q4. Just--Ken Xie, I just wanted to get your initial thoughts on your fourth quarter. How does this compare with what you saw, maybe, entering Q3 and last year Q4?

I guess you don't like--you don't want my answer, huh?

I think, like Ken Goldman said, the guideline we provided--it's still early for the quarter to say anything beyond the guideline we provided.

Okay, no problem.

And related to that, I guess, you mentioned you saw a better economic backdrop and better IT spending. Are you seeing an overall heightened security refresh cycle, and everyone's just benefiting from it or do you think it's still a matter of taking market share? I just wanted to get your thoughts on that.

We do see some more expanding in the security spending, especially if you can see the product growth, 41% year-over-year, is running ahead of the service renewal growth--I think it's about 27%.

So, that's really customers waiting to buy the new product. So, the products eventually become a base for the future service and renewal revenue.

Yes, I think what you're seeing a little bit is that there is a pent-up demand now to go through proof of concept, new deals and so forth. Some of the larger deals do take longer time, however, to close.

And so, I think we're--in '08, and certainly in '09, there was a reluctance, particularly in the financial services industry, to do much other than incrementalize what they needed. Now, I think there is a greater propensity for them to relook at their architecture and to do--to review larger possible deployments. But, they do take longer to close.

Okay.

My next question is just around linearity. Anything out of the ordinary or was it just a typical Q3?

No, I think it's--I mean, we had some linearity, but I wouldn't say it was that atypical either. And it also helped us from an overall collections point of view.

We did have some good--we did have a good start to the quarter, and that did help us, as I said before, in both collections and cash flow. And so, it may be a little bit better than normal from that perspective.

Okay.

And just last question. You mentioned that all geographic regions performed pretty well. In terms of the pipeline, any particular geographic region going forward looks more exciting than others?

We don't initially talk directly to the pipelines, but my own sense is for awhile we have wanted to grow Americas faster because we felt we were underpenetrated vis-a-vis the size of market. And so, that was--we saw some of the--we saw some success there, if you will, in the Americas in terms of their growth.

I think in terms of Q4, I don't know if I see too much difference in terms of the overall growth we provided in terms of growth by regions as I see it right now. So, I don't have any more detail since it suggests that's probably about right for the growth in the various regions across the world.

The other thing is that we probably will typically invest more in the US and Canada market. It's probably the biggest market in the security space, and we have two-third of our people in this market. But, right now only accounts about one-third of our business. So, that's the area we feel we can encounter more growth.

Okay, great. Thank you, guys.

Thank you.

Thank you.

Our next question is from Jayson Noland of Robert Baird. Your line is open.

Great. Thank you.

A few questions if I may, first on some of the larger deals. I wonder if you could talk through what these are like, how long the deal cycle is? Are they rip-and-replace of competitive equipment or are they viewed as incremental to some of these buyers?

It's both, actually.

When I went through some--just a smattering of deals, if you will, some of them are effectively a replacement of another vendor or a company, which I called through.

Some of them are refill opportunities as well. And--so, the deals are presented--I can think of some that are purely refilled. I can also think of some where we're a replacement for an incumbent. So, we are seeing both types in our--in the deals we're closing.

And we're finding--you know, they all vary. I mean, we'll get some deals done within three or four months. And some others can take six to 12 months, particularly if there's a long proof-of-concept trial that has to go underway.

Okay. Let me address it in a different angle.

I think it's, in part, there are so many different-point solutions, and that's where the UTMs can replace a multiple-point solution. That's where we see the customer starting to use UTM to replace a few-point solution, even including some--they call them new point solution application control. We do see, of course, some customers starting--changing back to the UTM because it doesn't just offer one feature. The UTM offers users multiple features working together well and easier to manage and also lower cost--plus the high performance for the ASIC.

So, we do see some kind of replacement of the single solution in the market quickly accept the UTM right now in the enterprise.

Okay, that's interesting.

As it relates to service provider, and specifically some of the larger global Top 10s, would you describe your penetration into these carriers as still pretty--it's still relatively early days?

Yes, it's still pretty early days because it's a long-term trend for the service provider to offer the value-added secure service. Right now they're just starting to take off.

Okay.

And then, last question for me on--it doesn't seem like there's any changes in the competitive landscape. I wonder if you gentlemen expect to see Cisco or Juniper or Check Point get more aggressive here given the momentum of this market.

On the product technology side, we don't see much change in the competitive landscape. We continue to lead in the product and technology with the new release of the new--our new product and also the ASIC chip, and plus the monitored Wi-Fi solution, we feel we're keeping gain in the market share.

Yes, I think that's true.

But, I think you also--the nice aspect, to me anyway, in this market is it is a growth market. And you are seeing others participate in that growth. And, frankly, I think that's healthy in that we're not just grabbing share from each other, but we are participating in a very healthy growth market.

Congratulations, gentlemen. It's impressive.

Thank you.

Thank you.

Our next question is from Erik Suppiger of Signal Hill. Your line is open.

Good afternoon. Congratulations.

First off, the high-end part of your business--the high-end products have been doing very well. Can you talk a little bit about is that being driven by service providers that are doing managed services or is that being driven by resellers or by enterprise consumption?

A bit of all the above, actually. You know, it can be--but, I think it is, sort of, all the above. But, I also think it's because some of the products we've introduced in the last three to six months have been focused on that.

The thing I do want to caution a little bit is we are very interested in the mid and lower side, if you will. And we will be bringing up products in that end, so I wouldn't--I mean, it's like anything else. The important part is to grow the pie. And we are seeing a little bit better percentage in the high-end, but I just want to point out you may not see that every quarter as we are going to introduce products in the middle and the low end. And we believe we can definitely gain some share, especially in the SMB space in the US.

On Europe, any thoughts in terms of the economy over there? Are you--are there any areas where you're seeing some weakness, maybe in the UK?

No. The UK was okay in Q3.

Again, I think--I always forget that we're still a relatively smaller player in certain markets in Europe, the UK being one of them. And so, I'm not sure our business is indicative of the environment there or not.

But, I don't think we saw any real sign in any one country there that would suggest the economy one way or the other.

Okay, very good. Congratulations.

Thank you. (Operator Instructions)

And we have a question from Rohit Chopra of Wedbush. Your line is open.

Thank you.

I want to ask you three questions upfront. First question is did partners contribute to the outperformance? Second question is with semi companies buying security companies, how do you see the competitive landscape changing? And my last question is, is there a product area where you think that you guys have a hole and an acquisition makes sense?

Well, let me start, and Ken can join in.

I'm not quite sure what you mean by partner outperformance because effectively all of our business goes through our partners. And if you're asking on any one in particular, outperformance versus the other, to my knowledge I can't think of any one. So, I don't think that was a leading indicator for us at all in terms of the quarter in terms of how we did.

You know, Ken may have a perspective. I think it's sort of not great for us to comment on another company's acquisition of a security company. And so, I think we'll see how that all goes over time.

In terms of--then you asked about product areas that we're delinquent in--don't have enough of. I'll let Ken talk about it. I think we're pretty comfortable going with our primarily organic approach. But, I'll let Ken talk to it.

Yes, I think the UTM--like, once we introduced the new version 4.0 one year ago, last year, we keep integrating more features into the FortiGate appliance. That's where we feel--that's the long-term strategy. We integrate more features into the FortiGate or ForitOS, and then leveraged FortiASIC to offload some of the top performance burden to the FortiASIC. And then, leave room for the CPU to keep adding some additional features once we see the new application.

On the other side, we do--like, early this year we announced the Wi-Fi solution to work with FortiGate together. So, that we see starting--going out quite well.

Also, I think right now we are pretty happy with our product line and--but, definitely we're closely looking at the space, and if we see any new application or new market to work with a current solution, we're definitely open for that.

Thanks, guys. Appreciate it.

Thank you. (Operator Instructions)

And our next question is from Erik Suppiger of Signal Hill. Your line is open, sir.

Erik, you're going for a second one, huh?

Yes, just a follow up.

We've heard some issues with support. Have you been making any changes or investments in your tech support?

We have a new leader join early this year from Nokia Check Point that's very experienced supporting VPN, Mike Anderson. We have good improvement, and also we're starting to hire more people in the US and Canada to support locally here. So, that's the model we have for supporting--each region was supporting locally with the people very close to the customer.

I think we are keeping improving, but definitely there are some areas we need to keep doing a better job. So, that's the overall--but, for supporting, it's very important for us. I think we made some good progress in the supporting and renew, but there's still some room to keep improving.

Yes, I mean, you will find, I think, as our goals have sort of outpaced some of our expectations, we do have to ensure some of the infrastructure keeps up.

My own sense from watching it is I think we've actually improved a bit in that area. But, as we've grown--particularly in the higher-end, we are in the process of adding more folks into that area.

Very good. Thank you very much.

Thank you.

I now would like to turn the conference over to Mr. Ken Goldman for any closing remarks.

Well, good. This looks like we have no more questions.

So, thank you. We did have a relatively longish--we've got to figure out how to shorten it a little bit relative--in terms of our script, if you will, and our comments on the quarter.

But, we do feel quite good about our quarter. We feel good about the business we're in and our expectations. And so, I do thank you for listening in.

And just to remind you, in about an hour we have another call for those that have any particular specific questions relative to the guidance or relative to the financial model that you're working on. So, feel free to call in, in a little less than an hour.

Thank you, again.

Ladies and gentlemen, thank you for your participation in today's conference.

This concludes the program. You may now disconnect. Have a wonderful day.