Fortinet Inc (FTNT) 2011 Q1 法說會逐字稿

Good day, ladies and gentlemen, and welcome to Fortinet First Quarter Earnings Financial Analyst Q and A Session. At this time all participants are in a listen-only mode. We'll conduct a question and answer session and instructions will be given at that time. As a reminder, this conference call may be recorded.

I would now like to turn the conference over to Mr. Ken Goldman.

Actually, it's all going to be Q and A so the only comment I will make is reminding everyone that the forward-looking statement disclaimer I provided earlier for the call and those forward-looking statements and risks and uncertainties apply to this call as well.

So, with that, operator, this is Q and A so we will go right into it.

(Operator Instructions). First question comes from Sterling Auty from JPMorgan.

Sorry, I wasn't on the earlier one. We just had too many earnings all at once this season I guess.

Who did you put ahead of us?

Well, listen when you blow off the numbers like you did and it's a clean quarter you've got to focus on ones that are messy like [Acomai], so I had to focus there tonight.

That's a good comeback. I'll take that.

So listen from my part just two questions; one, can you give a little color in terms of the competitive dynamics in the mid sized part of the market versus the high end? In other words, it seemed like during the quarter a lot of the conversations with customers it seems like you're gaining a lot more traction against particular vendors in each one of the segments. I am wondering if you're seeing the same thing from the high level.

Well, my sense if you sort of think about what's happening is I think we, as a Company, this goes both ways but I think we have momentum that's helping our sales force when they're dealing with customers and so people want to work with us. They know we're doing well. Our products are in many cases relatively recently introduced and so we have that working for us. The channel is working better for us. I think in the case of some of our competitors in the low end they've been bought out by private equity. I am not sure. It's hard to tell in numbers but my sense from what I hear is they're not doing as well. So you have that going on.

As Ken noted, some of the network security providers their products are lagging right now so that's helping us from a competitive situation and so I think we are gaining by better sales presence, better coverage with our channel approach and our service provider approach, as well as a continually refreshed product line.

Yes this is Ken Xie. And also probably you'll know well when some company being acquired by the bigger company the innovation kind of slows down and also some other people leaving. That's the case of my previous company so that we see happening in the space also because some of them are acquisition that we see they are much slower on response to any of the changing of space.

For us we have a much higher percentage invested in R&D and also the team working pretty hard to keep the innovation and keeping full of the changing in space and that's actually driving the product technology way ahead of the competitor and also the ASIC, the investment of ASIC we started to see the benefit after a few years of keeping investment in there there's a benefit of the ASIC put in the newer appliance that is ASIC has a huge advantage. I think all these factors we feel kind of make us grow much faster than competitors, probably more than double the competitor growth rate in the space.

That's great and actually you touched upon the second question, which is I think you revved the ASIC last year. Does that mean that 2011 we shouldn't expect another generation of the ASIC so could we see product margins improve throughout the year as you kind of gain leverage off the investment and on what you did last year with on the ASIC side?

We continue keeping investment in ASIC. You know, there's a three-chip family going on. One is really what we call the content processor. That's in any of the UTMs with acceleration of content application. That's in the content processor. Another one modeled is the high end, is the network processor. That's more driving the network speed -- I mean performance in the middle, the high end appliance.

That's where the few new appliances are released recently leverage a new chip we released last year. And the other thing is really we have the system on chip we call the FortiASIC ISOC, system on chip. That's integrated CPU and integrated some other ASIC function into a single chip. That's really helped benefit the lower end. So last year is the first year we released the system on chip solution into the lower end and then later they see we have the second generation chip come out. That's also what's dramatically improving the performance, also lower the cost. So that's what gave us more advantage into the lower and in the SMP, even the home user market. So that's the three chip family we continue to drive. But each chip usually takes about two years to make the chip for each generation so we kind of continue to keep the chip coming out to improve it.

Great thank you very much, guys. I appreciate it.

Keith Weiss, Morgan Stanley.

A couple of numbers questions for you, one on the accounting impact change, you talked to us about $0.06 to $0.07 on EPS for the full year offset by $0.02 FX. Did you give us a full year revenue number of what the impact is going to be there?

Yes Keith we didn't give that. I mean it was 3.3 in the first quarter. My guess is each quarter it will be in the range of somewhere between $2 million and $3 million.

Okay so somewhere around $10 million to $12 million for the full year?

If you add $6 million to $9 million it could be as low as -- yes $10 million to $11 million. I mean it's a little hard to say but I -- that's $10-ish million plus or minus.

Got it and then in terms of the margin guidance of 20% for the full year, even if you back out the impacts of the accounting change on this quarter, I think the operating margin was still around 19.7% and if we look historically the low point of your margin has always been Q1. What would cause operating margins to be basically flat for the rest of the year? Well, there's a variety of things that I -- you know, first of all I look at this. We are early in the year and I always worry about what I don't know so I always take that into account.

Two, is I am concerned about the full impact of FX. I mean the dollar, I don't know where the dollar is going to end up in terms of lowness, so I am just hedging my own self relative to the dollar in all of that. And then we are partnering and depending upon the exact timing of hiring I mean we certainly -- last year we got the benefit from expense point of view that hiring never hit our goals and FX was actually favorable. This year I look at FX going unfavorable and I look at our ability to hire more favorable if you will. So when I take all that into account and right now I don't want to over set expectations, given the world we live in so I'd rather stay right where we are.

Got it and then in terms of the full year guidance for revenues and billings, I think revenues came up by about I believe it was $20 million at the midpoint.

Yes we took revenues from where the low point went from 370 to 390 and the high went from 385 to 400.

Right and you had about $5 million of out performance versus the midpoint of your guidance this quarter, $10 million to $11 million coming from the accounting change, so on an apples to apples basis it was only up about $5 million versus billings, which are coming up by $15 million. Any reason for the change of why the guidance for billings would be more aggressively moved up than revenues?

Well, first of all, I think you've got a couple apples and oranges. If you look at Q1 we got about $3 million plus from the revenue guidance, revenue change and about $3 million I think really from roughly from actual performance so I wouldn't call it 5 in terms of performance so that's the first point.

And then the other point is I think this is a good way to show movement, no reason to show more movement given we're done one quarter and so I think I was very clear. We will put Q2 behind us in July and then we'll take a refreshed look at the rest of the year in July but I don't think there's anything to be gained at all by frankly your numbers or our numbers by getting ahead of ourselves.

Got it so but no change in sort of the relationships between billings and revenues is what I was trying to get at in terms of billings should come onto the income statement slower than they have in the past?

No I think the only change there is the increased coming about because of the revenue change. Other than that I am not aware, as best we can forecast any fundamental change in terms of conversion of billings to revenues.

Got it and then the last question from me would be on the cash flow statement. You talked about the settlement. Any other one-offs in the quarter in terms of positive impacts to cash flow adjusting that actually goes on that explains sort of the step down from Q1 to Q2? Was that just sort of normal seasonality in free cash flow?

Yes no it's that is a good -- first of all, it's good cash performance in Q1. I think when we'll look at Q2, we looked at some increments from our inventory as we add some products to go forward. We may be a little conservative but we've added some dollars for taxes and we do have some increases in expenses so those are the three real things that accounted for so the reduction, if you will, on cash flow from Q1 to Q2. The other thing I always point out is that there are a number of variables and moving parts in predicting cash flow and so I just want to be cognizant of that and not again get ahead of ourselves in predicting cash flow. But the three things I am pointing to is some incremental inventory builds. Two is some tax payments and three some, as we noted, some increase in expenses.

Nice one, thank you, guys.

[James Westman], Raymond James.

Hey, guys, it's James Westman sitting in for [Michael Turrits]. First question is what do you believe your cash tax rate will be for 2011?

Oh I haven't been asked that question. Other than what I just said I don't know the exact number. It's going to be relatively low though, probably somewhere in the single-digit percentage and it's really the benefit we gain by the ability to take the deduction of stock options, both in the U.S. and Canada because everywhere else there's a cost plus so we -- so basically our income is primarily in the U.S. but we get the benefit of various stock option deductions, both from employees in the U.S. and some employees in Canada.

Got it okay and then another question -- sorry, bear with me one second.

I'm not going to be helping Obama this year.

In 2010 we looked at the cash flow statement. We noticed you guys have about a $15 million benefit from taxes payable. Do you see that reversing in 2011 or 2012?

I don't have that in front of me so I can't really comment on that really. Why don't we just take that one off line because I don't have that in front of me?

Okay not a problem and then one other question, on the call you said that you guys were comfortable with the higher end of your free cash flow guide. What was preventing you from bringing it up even further?

Just because I'm early in the year. It's really nothing more than that. I mean the thing in cash flow, as I think I said before, there are a lot of moving elements and so what I don't want to do -- I mean, it's two things. Let's face it. One is there are a lot of moving elements and it's only Q1 and two is the challenge here is keep expectations reasonable because if you don't you can set yourself up for a fall and that's not good for you or us.

Got it. Thanks, Ken.

Todd Raker, Deutsche Bank.

Hey, Ken, sorry I missed the call again. I'll take Sterling's excuse here. There was a lot of interesting developments. The question I have for you guys is you guys just put up a phenomenal billings growth against a very tough comp. I just want to understand the Q2 guide on billings. I mean 22% when you just did a 34% year-over-year number, walk me through -- I know you're trying to be conservative because it's early in the year but from a Q2 perspective that's seems to be a significantly deceleration in the business.

Well, I would only say this. I mean, we had a phenomenal quarter in Americas in Q1. Americas for whatever reason in this Company, which is really pretty unusual for me in all the years I've been in tech, doesn't have the seasonality that I've seen in some other companies in terms of Americas.

Now we do have nice seasonality in Europe, so to speak, which impacts Q1 and helps Q2 but in this Company we don't see that so I am being cautious at the how far out forward I forecast for Americas, given they had such a great quarter in Q1 and I am thinking about we had an outstanding performance in Canada, outstanding performance in Latin America and some other regions, so I just want to not to assume we're going to have such out performance each and every quarter from their targets.

Okay and just as I look at Q1 two questions for you around the billings number, is contract length extending at all as you move into the large enterprise? Are you doing more three-year deals versus one-year deals? And then secondly, was there any substantial kind of FX impact on billings?

Well, first of all, on contract generally that's the case. I don't thing we saw that in Q1 but that's generally the case and that's one of the reasons why long-term deferred didn't go up as much this quarter. In terms of billings, no because billings are done in dollars as well as revenues and so we don't get any FX in billings on our dollars, our revenues. Where the FX impacts us is in our expenses and because basically all of our expenses, other than the local currencies in the various countries, are dollar denominated. I'm sorry, all of the other local currency, whether in Europe or whatever, those get translated into higher expenses and so that's what's really affecting us in terms of our expenses.

We happen to be a Company where a good amount of our engineering is in Canada. That's expensive. We have a number of people in Australia. That's become expensive and you have Europe and your dollar to euro is now 1.46, 1.47, whatever, so that's changed probably 10% if you will over the last six to seven months. We are looking at price changes and I don't want to say more than that right now and so we may or may not do some things there but you have to remember we have probably 45% of our expenses go through at -- actually I have that here.

All you need to do is look at our charts. I'll get a chart so I can talk from some facts here. What goes into -- now China is generally more "pegged" but if you look at it 38% of our employment cost is in all of our costs are basically in the U.S. so you can take all the other costs, the 62% on some form or another are not linked to the dollar and so whether you're looking at Canada, which is 27% where clearly the Canadian dollar is in very strong, that hurts our expenses. You see France 10% and so forth.

Okay and then the last question I have for you is this is the fifth quarter in the row with billings growth north of 30%, which is just phenomenal performance. The last time I saw an industry report in terms of kind of the UTM industry they had it pegged at growing about 15%, mid teens, so two questions. One, what is really driving the growth profile you guys are seeing? Is it all competitive share shift or do you think the UTM market has really accelerated? And if you look at the market opportunity out there, where -- what inning are we in in terms of UTM penetration in your mind?

I think that the UTM market definitely are keeping growing faster and but on the other side, like I said early of the call, like a few years ago there's a few vendors actually switched their label from the firewall into the UTM without truly investing the UTM function like (inaudible) some other intuitive function built into the box. Now they are starting to see the drawback of the change of label instead of keeping built a true UTM box so that's what we see probably slowed them down compared to Fortinet is doing today.

On the other side, I think that the true UTM definitely has more advantage computer, the firewall market which is really kind of out of date technology to [share] the current way that enterprise customer or some other carrier of the SMB customer. I think that we do feel that the benefit of a UTM quite huge compared to the traditional firewall and also at the refreshment of the old firewall probably will be a steady come up in the next couple years, so that's where we feel that the UTM managed from Fortinet point of where we see the huge growth opportunity there.

And, as you look, Ken, as you look at the large enterprise where you're starting to see some nice traction, are you typically displacing a legacy firewall or is it incremental deployment?

I think that the large enterprise tends to first put a UTM behind the traditional firewall and then gradually replacing it so that last case we see more often compared to just totally replace it right away or just coexisting.

Okay thanks, guys.

Adam Holt, Morgan Stanley.

Another great quarter. I had three questions and Todd was just asking about one. If you look at your large deal activity, I know on the call you called out not only enterprise but also taking some share on the service provider front but it's unusual to see an acceleration in large deals in the first quarter so I guess my question is, and I think you just mentioned that your seasonality may be a little bit different, but was there anything anomalous about the large deal activity in this quarter, either in terms of spillover from the fourth quarter or anything unusual?

And, as you look into the pipe, should we continue to see the kind of $500,000 plus deals that you did this quarter be a bigger percentage of the mix?

Yes that's a hard one to tell. I mean we could have totaled it all up at the end of the quarter and see what we did. We don't drive that number as much during the quarter as we do making sure we hit the billings number, which does drive our business. I think the thing that surprised me this quarter is there was no one deal that was so large that we were tracking it that would have a measurable impact if you want our overall numbers so we had, as you saw, a number of large $0.5 million type deals but no mega, mega deal, if you will.

And, again, I think if anything else it's really indicative of a strong Americas, both in terms of enterprise and service provider business. I do get worried though that I don't want to get too hung up on one quarter's trend and so that number -- I don't know if that's a -- I wouldn't call that a leading indicator number for us, as I would billings or product revenues. It's a number that really may reflect from one quarter to another just getting a number of deals done.

The last point I would say is I don't think it really reflects spillover from Q4.

This is Ken Xie. I may add a little bit, maybe credit to I think it's about one or two years ago we started structure, restructured the sales force a little bit, more focus on certain verticals markets compared to in the past, more like a regional base, which tends to drive the short-term revenue or the smaller deal, which can get a deal quicker but with the focus on certain vertical markets, build a team focused on certain vertical markets I think that that's probably a help in driving some larger deals going forward.

Perfect. My second question is about your headcount investment. You called out in the call both investments in R&D and sales. To the extent that your top line momentum has been as good as it has been over the last couple of quarters, does that change your assumptions or what you're seeing in terms of sales productivity and the time it takes to get people productive from a new sales perspective?

I think the extent that we're able to bring on people that have a rolodex of customers that brings them on much quicker and we have seen some of those folks come on so yes there is a quickness and I think we're probably getting a little sharper in terms of who to hire as well and so I noted that we saw 4% I think productivity improvement year-over-year in terms of sales so I think we still are seeing that and we continue to prune, if you will, folks that don't cut it and so we have all of that helping us sharpen our pencil.

And all year on your basis for calendar '11 what would you like to see your direct sales capacity grow?

I don't know if I have a number. I mean I think if I looked at that I mean if you just take it I sort of assume roughly comparable margins, which would say sales would show some productivity but because other areas like R&D mix can go up a little bit as a percent of revenue. We'll see. So sales capacity may go up pretty comparable to billings capacity or billings.

Okay and then my last thing is area of questions would be on a couple of areas in particular, Japan and then also federal. You called out that Japan was flat on the year-on-year basis. Obviously it was a difficult environment in the quarter. To the extent that deals have slipped into the June quarter, how does that change your thinking about the potential contribution for June and what under -- are you assuming that you get those deals back underpinning the Q2 guidance?

Well, there's a couple things that go. First of all, we don't -- I don't want to get into predicting country by country. I would say that there are two conflicting trends going on in Japan. One is you have the benefit in Q1 of their fiscal year-end. March quarter tends to be the strongest quarter for Japan for us. The positive impact to some extent is some deals that may have flapped over into Q2.

The other thing is though, which we take into account, is the unfortunate aspect occurred I think on March 11th, which is only a few weeks before the quarter ends where it affects all Q2. So, without getting too specific here, there are trends that I don't think Japan is going to turn us one way or the other in Q2 just because A you had the fiscal year-end in March. You only had a few weeks of the unfortunate situation occur in that quarter and yet you will have some deals maybe close in Q2 that otherwise would have closed in Q1.

And then on the federal side, it's not a segment that's been a huge contributor to revenue over the last couple of years but it sounded like you've seen a little bit of an acceleration there in a time period where other folks are seeing a more difficult selling environment. Can you talk a little bit about what you think is behind the improvement in the federal vertical and what the outlook is like and that's it for me?

Yes I would say there the case where we had -- sometimes we have the benefit of starting from below point. So we have that benefit. We have I think a pretty good team there now. We are getting ourselves named to do a number of programs and so yes I think if you had a lot of business there it is challenging because some deals do get slowed up because of the various budgetary constraints. But we are hopeful, and I'd leave it there, that we're going to win some reasonably sized deals that will contribute to meaningful growth as the year unfolds in federal and so we do think there's opportunity and that's part of the upside for us this year.

Okay terrific, thank you.

Eric Suppiger, Signal Hill.

Eric, you must have a question somewhere there.

Jonathan Hull, William Blair.

In terms of the linearity on the quarter, was there any I guess deviation from what you typically see or was this typically pretty back end loaded?

I don't know. I don't have the data from Q1 in front of me but I would say this, that it did start but my sort of memory of the quarter is it did start a little slow in January and we were going through some the adjustments you always make in commissions and getting everybody back employed from both finishing off the year and some holiday schedules, whatever, and so I think January was a relatively slowest, started coming on February and we did have, as I think I said, accelerating momentum as the quarter unfolded so March was strong for us so yes I think, again, I don't have exact data to compare and contrast against Q1 of last year but my general sense is it was still slowish this quarter, this past quarter.

Okay and as we talk about the accounting changes, I just want to understand a little bit better some of the discussion around the demonstration units and recognizing revenue now that you guys have sort of established the VSOE around that. Is there any potential variance between demo units for new products that you guys have just put into the channel versus existing product? I mean, how do we sort of think about any potential changes around that or is it just not that important?

No for that board made it's all the demo. It's a small piece of our business demo units and so we're not talking a lot there and it's a smaller of the two aspects that I pointed out, China and demos, it's the smaller of those two.

Got it. I think that's pretty much it for me. Thank you.

James Westman, Raymond James.

You guys just answered my question. Thank you though.

Eric Suppiger, Signal Hill.

Eric, you keep on trying. Take it off mute, Eric.

Can you hear me at all?

Yes now we can.

Looking at the product mix, your low end business has been growing at a pretty modest rate, 11%. Are you seeing customers that are migrating to the higher end products or is that just not a focus for you or is that something that's going to start growing? Is there any catalyst coming on that front?

I think that the low end sometimes will depend on the channel programs, some other things, and it usually takes some time to grow quick instead of sometimes the high end may drive the deal by some good sales force there so that's the part I think is the lower and it you're looking over the year that's kind of more smooth start because you really need to drive the reseller. There's a like a certain reseller. You need to get them trained, get them all the right tools to sell it. That takes some time. I think it's that we will continue to invest in the channel keeping driving that so that's that long-term strategy reason.

But if I hear you it's -- go ahead.

Yes I think the other thing is, as we noted, we are focused on the retail and so it's our expectation that we will really accelerate, if you will, some of the business that we're focusing on there and to the extent we do that may increase the low end somewhat so I always get a little worried about -- because again it's a pie chart and you really want the whole pie to grow so what I wouldn't get too hung up on any one segment because frankly we want all of that pie to grow.

Well, that's where I was going is you're at 37% at the high end. Do you think that that kind of gravitates up towards the 40-ish% range or where do you think that might go?

My own sense, and Ken may have a different perspective, is that may hopefully that's about steady state because I don't -- we definitely do not want to give up, if you will, the low end of the medium end because those are very, very important market segments and big market segments that again we think we can compete in.

Just to be clear, on the revenue guidance that you gave going into Q1, that was not assuming the contribution from the rev. rec. change, is that correct?

That is correct.

Okay then what is the tax rate? Do you have a suggested tax rate for 2012 or is there any reason to think it could change from 2011?

I don't. I mean, we are working on some things to bring that rate down a bit so I don't want to get you too excited yet other than trend wise I am hopeful we can bring it. You know, it's 33% non-GAAP this year. As you know, the GAAP rate is less than that, which is pretty unusual and so there may be some things as we get -- we go through some of our planning that allows us to take some of the GAAP opportunities and put them into a non-GAAP rate.

Would your objective be to bring it down a couple or few percent or is it something more than that?

It's a net amount until and such time as we fundamentally change our international structure, which won't happen overnight.

Okay thank you very much.

(Operator Instructions). Alan Weinfeld, Kern Sussalo.

I just was curious about the gross margin on products. You've done a great job over the last four quarters of raising that level to 65%. Is that just through the tremendous growth in revenue and basically putting to the products the same way or can you do anything to consciously get better agreements with your suppliers since you're becoming a much bigger Company and still grow your revenues faster and maybe break that product gross margin into the 70s dragging the whole upbeat?

I think the high end product tends to give us a little bit better margin so that's where the make shift to the high end also because that's a benefit to us a little bit.

Yes I think there are two things there but that's one. The other one is as the volumes increases we're able to take some of our corporate operations overhead and apply that over a greater amount of volume so that brings the -- that helps the overall margin. One of the things we are and we look at cost reductions with our vendors each and every time we ramp up volume. I think we're going to continue to look at that a lot more on some of the higher volume units. My own sense is not anytime soon do we see buyers like you suggested for products. As a matter of fact, in the near term we'll be challenged just because again we had maybe a little bit unusually high mix of high end this past quarter.

On the other side the expenses, even if we have this unexpectedly high revenue growth continue through the year and say we do 500, my estimate not your guidance, we still couldn't look at a 21% and 22% operating margin?

You're killing me. You're killing me.

I didn't give you any credit. I said my number looks like 500 million and that wouldn't get me leveraging expenses to a 21%, 22% operating margin?

You know, again I think first of all I think your number is high. Whether it's your number or our number I think that number is high. Two is--

I think yours is very conservative but we could agree to disagree.

Then I guess that's true. I think, again, I think the area that I get concerned about, as we -- last year was very different. As we would go into the year the dollar was strengthening and that clearly was helpful tailwind, as they say for us and so everything we've seen this year is just the opposite. We have a headwind in terms of FXs and so that's the thing that worries me this year plus the ability now that we are finding better ways to hire so I do think we will add people, which will make a lot of sense for us to grow our business even -- well keep our business growing fast. So those are the things I think are a little different than we experienced in '010.

Would you put any hedging program on to lock in a certain rate on the euro or Canadian dollar?

We have done that from time to time in the past and perhaps we should have but right now we're sort of watching it and to the extent that we find a rate that we like we might do that in the future.

And does moving parts, as higher energy cost you even a 1% difference in anything in 2011?

I don't thing we're really -- well, I don't think there's a direct correlation, at least I know of relative to energy in our costs right now.

Great thanks a lot.

I am showing no further questions at this time.

Okay well, thank you all. We'll look forward to seeing your reports and don't take that high number as indicative of what I want to see for numbers here by anybody in terms of your estimates that you come out on us. So, with that, I will complete this call and thank you for participating.

Ladies and gentlemen, thank you for participating in today's conference. This concludes our program for today. You may all disconnect and have a wonderful day.