Fortinet Inc (FTNT) 2011 Q3 法說會逐字稿

Good day, ladies and gentlemen, and thank you for standing by and welcome to the Fortinet Q3, 2011 Earnings Financial Analyst Question and Answer Session. At this time all participants are in a listen-only mode and later we will conduct a question and answer session and instructions will follow at that time. (Operator Instructions). As a reminder, this call is being recorded.

And now I will turn the program to Ken Goldman. Sir, the floor is yours.

Thank you and I'm not going to go through the entire -- I'll just make a comment that the forward-looking disclaimers, Safe Harbor Statement that we noted earlier, applies to this follow-up call as well. So with that I'll just take -- we'll take the questions. Ken Xie and Michelle are with me again on this call.

All right and, ladies and gentlemen, if you would like to ask a question, please press star then one on your touchtone phone. (Operator Instructions). Our first questioner in the queue is Rob Owens with Pacific Crest Securities.

Just one quick one, could you address some of the management changes over in Europe and whether that was a result of anything that may have happened during the third quarter or whether that's some of the reason I guess for the conservatism as you think about Q4 and guidance?

This is Ken. You know there's actually been few major changes. There was one that occurred recently and that's where Luca decided to move on and basically retire for a while. And so he was heading up part of Europe and it just became better for everyone mutually for he decide to move on. And so that really was the only change that occurred. The change in relative to heading up U.K. occurred about a quarter ago.

We have back filled a number of people in the U.K. We feel very good about our organization there. But other than that, you know there's always like in any company across the board there's always going to be some comings and goings. That's just the nature of the beast, but that was really the only thing that really occurred this past quarter.

Right, thank you.

Tom Ernst, Deutsche Bank.

Hi. It's [Charles] on behalf of Tom Ernst. I'm trying to get a sense of how the ASPs trended in the quarter, anything comparing ASP this quarter to maybe ASP in Q3, '10 or Q2, '11?

No there's nothing really fundamentally changed with pricing if that's what you're asking. It always -- there's always a lot of things that do evolve in terms of the mix and bring on new products and whatever, but nothing fundamentally changed in our pricing approach this quarter.

Okay and I have just one follow-up. You mentioned that most of the revenues being recognized up front, which is being deferred and that's how we have that strong growth in revenues and not such a strong growth in deferred. Now, does that mean that there are more products being sold with less services attached to them?

Let me be clear, let me be clear. I did not say most of the rev -- most of the billings is being recognized up front. That would be a wrong statement. The -- we do have a certain percentage of our hardware related billings are coming with, not coming with services, particularly subscription services and that was a point we made earlier that some of those will be the firewall related or non-FortiGate related. And so that percentage has in fact increased somewhat this past couple quarters, but I did not at all say that most. That would be over stating it. It's about roughly of our billings it's roughly 60/40, not exactly, between hardware related billings and services related billings and then the hardware breaks down into bundled and non-bundled hardware.

But it's about a 60/40 between hardware related billings and services and that is up a little bit from what it used to be. For those that remembered when we first went public, that was sort of in the mid 50s in terms of hardware related billings and now it's somewhat over 60. So that has come up a bit over time. And part of this relates to the new -- in terms of how we recognize it then it relates to new rules, new revenue rules.

Okay well then the make shift towards hardware that would not result in subscription revenues, right? I mean if you sold a FortiGate?

I'm not sure because to the extent that there's a mixed shift of hardware, that is not necessarily the case because that could be bundled hardware in which there wouldn't be a change. It's only to the extent there's a mixed shift to hardware related billings that those billings do not include subscription services that you would have a change to allow you to recognize a lot more up-front revenue.

Okay and just one more question, this is last one. Cash taxes, you said 2012 should be the same as 2011?

Yes.

And that's driven by -- and also that's you said that was driven by (inaudible).

No, it's really driven by stock option deductions.

Okay, perfect. Thank you.

And again it gets a little tricky and I'm not going to go through it here, but it gets a little tricky relative to how we display that on the cash flow statement in terms of whether that goes into operating cash or financing cash. And I'm just not going to go through that right now because it's a little complicated (inaudible) and we haven't put that all together, but if you're thinking of really, what really is the drivers of the increase in cash, the fact is we will be paying very modest amount of taxes in cash.

Perfect, thank you.

Sterling Auty, JPMorgan.

So following a little bit so when you think about that shift between the products, you know billings and the up front revenue recognition versus spreading it out, you said that had something to do with the seasonality in terms of what revenue in the fourth quarter. How much of an impact did you guys kind of bake in? Is it similar to kind of the $5 million tailwind that we saw in the third quarter or a little bit less or?

I can't get specific but Q4 is absolutely different than Q3 because in Q4 we do expect a higher amount of potential renewals that we can renew than we had the opportunity to renew in Q3. So we are expecting a higher percentage of services related billing in Q4 than we experienced in Q3.

Okay and that's--

And that's why I was specific in saying we expect to see deferred revenue balances increase by $15 million, maybe $20 million in Q4 compared to Q3, because of the higher amount of billings compared to revenue recognized.

And then on a different topic, as you look at the product introductions that you've done, how would that impact potentially the mix of the low, mid and high products in the fourth quarter and how would that mix ultimately kind of impact gross margins?

I don't feel we'll be impacting Q4 and the next year we feel leverage the new product in the middle range in some new low end. We can have a better position, more gain in market share into the middle and the low end, but I think that the Q4 don't have any impact because first the channel needs to take time. The customer needs to take time. Also we need the time to ramp and the manufacturer is still involved in early stage.

Yes there's really two points here. One is we'll get some impact -- I mean some contribution for the new products but it won't be -- it will take a while to ramp up, as Ken notes. The other thing is it's been a philosophy of ours for a long, long time that we bring out new products at approximately the same price points as the products superseding and the gross margins are comparable and so we bring out basically more performance for the same price points and that's one of the ways we gain market share. And so the new products are generally comparable to the margins on the products that are superseding.

All right great. Thanks, guys.

Jayson Noland, Robert W. Baird.

Just a couple quick questions; Ken, if you could remind us what your typical renewal rate is?

Yes it's in the mid 70s to upper 70s.

And that's what you would expect to see going forward in the near term?

Yes and that's where we finally achieve from the renewals that are available in a particular quarter by time they're either fully renewed or in some cases they get -- the customers don't renew them in the 20%, whatever. They would go for a subsequent product.

Okay, last question from me on Cisco. They've been more vocal about focusing on security and some of the channel has said that its going to take at least a year for Cisco to get new security products out the door, but have you seen anything change over the last quarter or so from a pricing standpoint or relative to Cisco in your competitive -- from a competitive dynamics standpoint?

This is Ken. We don't see much in Cisco in the last one or two quarters, even they talk more about security. I agree with you, we'll probably take a year to two to come out the product now so competing in the space. We do see a lot of some enterprise in retail customer. In the past Cisco have a good on the router switch, try to leverage that part, and that will gear to kind of compete in a secured space, but we see more and more customers starting to feel the Cisco solution lacks the functional performance in the security parcel. That's where we're kind of starting replacing some of the Cisco security, even the networking part still using Cisco Juniper product.

Thanks, Ken.

Keith Weiss, Morgan Stanley.

A little bit different topic here, the slide you showed on employee productivity is very impressive. You guys have been making great strides in that for going on four years now. The question I wanted to as to Ken was, are you starting to reach any kind of upper limits there, particularly when you talk to sales productivity or do you feel there's a lot more room you could go with improving that sales productivity? And specifically into calendar year '12, should we be thinking a lot more about hiring being needed to sort of get these same types of growth rates versus those productivity gains?

Yes I think you're absolutely right. I think for a while we are getting to the upper limits. I do think we need to not only in sales but in service support. We need, clearly in R&D and quality we need to continue to grow our organizations and as we enter some emerging -- continue to enter emerging areas of sales. So my own sense is why I sort of suggested margins comparable in '012 or '011 is I think the growth in headcount -- frankly our goal is going to be grow a headcount pretty close to revenue growth in '012 so that we can add some investments in the areas I just mentioned.

And so I think when you get into the 300,000 I think we're now doing pretty good. At the 150,000 I think we were sub par and now I think we need to work on some the areas that we still have. We can improve upon our execution.

Got it and then just in terms of your ability to find those heads that you need, at the first half of the year I think it was a little bit harder. You talked about that loosening up last quarter. Are you still able to find the guys that you need? Is that -- which direction is that labor market going for you?

We still have a lot of open we can not fulfill, especially from engineer from a technical position. It's still we're competitive whether in U.S. or Canada to find a good engineer. We right now we have a headcount I think close to 1,000 if we count all the U.S. and Canada but it's really we have probably about close to 100 open right now and we're keeping -- trying to fulfill it. It's mostly more come on the technical position.

On the sales side is also securities kind of pretty special area so it's people with experience and no experience can make quite some difference there. So we still try to build up the team because for us grow faster than the market. That means we also have to hire and faster to keep up the growth but I have to say that hiring probably a little bit better compared to early this year but it's still kind of a pretty challenge to get the certain area to hiring as we planned.

Got it and if I could sneak one last one in, really appreciate the detail on vertical breakout of your billings or top five verticals. If we were going to go back say two to three years, have there been any significant changes versus those kind of full-year ranges that you gave us in terms of who are the top five verticals for you guys?

Well, again we have someone sitting in here. He's patting his back two different ways, much as his hands can get quite that far as he's all happy with your comments. But the -- we actually just started to look at the data. It's not easy because again we go through a channel but I would say if you think about it, clearly in the area that has increased is retail. So that would be one of the areas. My sense is service provider has probably gone up a bit too over this time. I'm not quite sure what areas have gone down, but I would sort of point to those two as probably gone up over the last three years or so.

Excellent, thank you very much, guys.

Michael Turits, Raymond James.

So a couple of questions; first, I know you started to address this in the call but does it feel like next year is the year in which billings and revenue can grow at the same rate, especially since you're coming off a year in which billings did grow slower?

Yes now I think that's actually true. If you go back we've had years in recessionary time frame in which revenues grew faster than billings and then we've had years like where it was just the opposite. And so they do -- you get into an equilibrium which my sense given -- you know it's only October right now, but my sense is next year they will probably be closer to equilibrium as we basically have a steady estate growth rate so I think that's the case.

And this year for that reason it looks like cash flow will have grown slower than net income this year and all of the things we've seen pretty much equally of tax rates were up--

Cash flow is still growing about 40% so that's nothing to sneeze at.

No, no, man I'm not sneezing, don't worry. But if it's still growing slower than net income so I'm just trying to level that for next year. So for next year billings and revenue are growing about the same rate and any reason why cash flow and net income shouldn't grow about the same rate next year?

Yes that definitely that was suggested, yes. If you -- first of all, if you assume the operating percentage stays about the same, that means your income is basically growing the same rate as revenue and I sort of agree with you that again early but that billings and revenue grow about the same and if that's the case relatively cash flow should grow about the same rate. Again, thinking of the definition of cash flow as I defined it before because I know you've asked some questions about this, without getting into the idiosyncrasies of excess tax benefits and so forth, I think the change in tax if you will probably we'll grow about the same rate as overall operating income.

Great that's really helpful because there's all this weird stuff floating around in cash flow. I just want to make sure we're not--

Yes I know and which is why we don't give a hard number for that and there is a lot. But I would say as we go into the year that's what we're trying to achieve.

A housekeeping one, a GAAP tax rate for this year and for next rate?

This year we got up to 29% if I remember the number, like 29% year-to-date and 34% for the quarter came up. There's a lot of things that go in there. I would say, given whatever I know now if you assume GAAP tax rate about 30%.

And about no reason, about the same for next year as far as you know?

Yes I think it's about the same when I look at some of these things that go in there. There's a few things that do affect it. Again it gets us back off to the deductions and which deductions we can take into account in our tax rate and which ones we can't.

And then last one if I could, Ken, just to go back to the shortening of the term lengths and first of all can we quantify what the average term length has gone from and to in terms of the duration of the contracts? And I just really want to make sure I've got the key reasons why it's shortening and make sure that--?

Well we haven't done -- at one time we said the average length was about 18 months but we haven't updated that number so I don't have a number for you that I can sort of even guesstimate. So I just don't know.

So is there any impact you think from something that some other companies have called out of company of customers getting more conservative with cash? Or let's really focus on what really are--?

No because if you think about it last year, you would have been even more conservative with cash and we had some longer term deals with Europe. So no I don't think it's that at all. Someone else also asked the question do I think it's economic related. You know, I think the best feel, not that we really ever gave incentives, but I think -- we don't give -- we basically -- the only real reason for a customer to do it for multi-years is that they want to lock in the rate and get it done with and frankly pay up front so they don't have to worry about it down the road. Sometimes there are certain customers will do that. Most see no benefit of doing it and so therefore generally won't do it.

Then they shift to service providers? As service providers they can get a bigger percentage and therefore and they take shorter terms. Is that an impact?

They would -- probably if it's MSSP probably more likely to be one year I would think in that business.

Okay and they're becoming a bigger part of the mix?

Well they did this past quarter.

Okay great, Ken. Thanks very much.

Rohit Chopra, Wedbush Securities.

A couple questions for Ken Xie; Ken, did you mention what -- in that large deal what product is actually going to be installed in the 8,000 locations?

Yes I mention that 200B and then there was a couple of other products too. Let me--

Yes, that's the 3000 and 5000 in the high quarter.

Yes, 4800, 5000, 3950, but primarily a 200B.

200B, okay.

That's the primary one, yes.

5390, all right and then--

No, no, 2000B -- 200B I'm sorry and then the 5000 and 3950.

5000 and 3950. Okay and then the other question I had was and I think someone touched on this. But what do you actually need at the Company as far as acquisitions? Where are the holes that you need? What do you need to fill?

There's no holes and I'm not being arrogant. We don't look at it from that perspective. The opportunities we really look at is can we acquire technology and talent at a more effective price than trying to build it ourselves or B, can we gain some market share in certain segments faster because of the inherent customer base of the acquired companies.

And then third there are some times complementary technologies that we -- if you look at some of the other non-FortiGate products that have come about because of acquiring companies, so we acquire capabilities and some of those products. There's none in particular that we're looking at that I would say. So it's not like we -- so it's a little bit like can we ask them if it's complementary and that's like filling a hole in our product line. At least that would be the perspective I would give you.

Thank you.

Adam Holt, Morgan Stanley.

Terrific, thank you. My first question is about--

Is this the real Adam?

It's the real Adam right. The World Series doesn't start for another hour so I am just killing some time here in the afternoon. I was -- wanted to ask about the multi-year comparison that was tough this quarter. As you look into--

Hey, Adam, let's go back to the World Series.

If you look at the next several quarters do you have any quarters where there is another difficult comparison where you had any kind of an aggregation of multi-year contracts?

So yes I'm looking for my guys here. I think probably not because this year if we haven't had the multi-year contracts that we had in a couple quarters in '010, so therefore I think it will be -- if from that perspective easier comps.

Okay, perfect and then secondly the deal, the large retail deal that you did where you said it will be billings spread out over multiple quarters, is there something unique about that contract that enables you to spread out the billings or is that something we should expect to see out of the larger deals going forward?

Well the only thing I would say here is that they were willing to put a contract together for all 8,000 stores up front. More normally you would get a contract for just a certain percentage of the available stores and then you'd extend it. So in this case -- but again they have to still provide purchase orders each quarter so we're still subject to that, but the contract is for certain priced number stores number used, blah, blah, blah over a number of quarters and then they would each quarter provide a purchase order against the contract and we would bill and ship and revenue rack based upon that.

And is that a model that you're going to try and move to more with these larger deals to eliminate some lumpiness or is that kind of more of a one off?

No I think it's more -- we don't have a strategy per say but some people that are working these deals for us, there are other examples that we think can apply here and that we would try to achieve and it's more so to lock up business for a long period of time and so basically you get that customer's entire business. So I don't think it's -- it's not strategy of making our business less lumpy so to speak as much as getting all the business we can from that particular customer. And, frankly, it's good for them too because they get to negotiate once and for all and they don't have to worry about pricing or other terms or conditions down the road.

Perfect, just two more quick questions for me. Europe obviously accelerated on a quarter-on-quarter basis. You talked about some of the individual countries that were strong but why do you think that was? I know you made some changes internally. You talked last quarter about better execution, but you don't hear a lot of people calling out France as an area of strength like you did.

I like France.

I do too, but I'm just curious as to why you think either you saw that either not just sort of the status quo but actually an acceleration in growth in Europe this quarter.

Well, if you go back to, and I know some people didn't actually want agree with us, but if you go back to our comments last quarter, we really did feel that there were -- you know there were issues both -- I gave three reasons. I gave the reason of the environment. I gave the reason that we didn't execute well and a little bit specific. Countries didn't do as well and I pointed out U.K. and Middle East.

We felt it was very much so work that we could have done better and so therefore we felt confident it would be not a cockroach issue as you know where you have one; you leave one and you have a bunch of others, that we felt that we would have some recovery this quarter and that was what, you know, we have work to do. We're not where we need to be at all but we had improvement and so I think what you saw is our recognition that we didn't feel we executed nearly as well as we could have in frankly Q1 or Q2 for that matter and it had to do with a whole variety of issues that I don't want to say I'll go into every one, that we thought we could do better in Q3 and we made progress in Q3, which is the term I used, but we have work to do. And so that was you know, and so I know some people don't necessarily believe us but that was what we said and I think it turned out to be true for Q3.

That's perfect and then just one last question for me, as we're looking at our model for next year, I want to make sure that we get the first half right. Should we be looking to this year or this year and last year for sort of quarter-on-quarter seasonality guidance for the first quarter and any color you can you can provide on how to think about getting the year off on the right foot in Q1 would be terrific.

Yes I mean what we try to do, I don't have detail yet by quarter. What I always worry about is getting -- is the investment community getting ahead of us in some of their thinking and so I think the overall guidance I gave for the year is as best as I can tell right now representative of year-over-year data for Q1 and Q2 of this coming year. I don't recall anything that specifically unusual about either one of those two quarters. I am looking at my folks. I mean obviously in Q3 I don't want you to put in a patent sale that we had this past quarter but I think relatively I think everything else is probably comparable and, again, our approach is with limited visibility without the environment, with all these red flags throughout the economy we just want to be prudent in our thinking as the year goes on.

Got it. That's helpful; thanks again.

Aaron Schwartz, Jefferies & Co.

I just wanted to ask a follow-up. I know several have been asked but on the billings mix I mean if your value add is a company is to have multiple subscription services per box I mean why didn't that occur in the quarter? Is that purely a vertical mix? I mean, are service providers more likely to just buy the firewall? And then the follow-on, what do you do to fix that? Is that more of a special, a sales fix, or is it product packaging or what can you do going forward into next year?

I don't necessarily think it's a fix. I mean, again, I think to the extent that we can open up a market that is that we hadn't really addressed earlier that's more pure, more firewall related, that's an opportunity for us that I like and so that will say that there are certain customers and products that may not have attached subscription services with them and so that has to do with that. I mean clearly there are some -- if you look at year-over-year there are some things that cause revenue to grow faster than billings and that's the various things that I pointed out like revenue rec in terms of some of the China business and whatever. But the attachment rate is really -- I mean there are a variety of things. You're going to see that some of these numbers change in Q4, as I project they will, because we have a lot more renewals coming up in Q4.

In terms of the mix of products, as Ken pointed out, it's still a relatively small percentage of non-FortiGate products. Well we do we want to ship more non-FortiGate products as well as FortiGate products so we do want some of that non attachment rate to increase if you think about those products so I don't think you can take a trend on this other than it's important that we get the overall number growing hopefully even faster in billings.

Okay that's helpful and if we think about your hiring, you touched on this a little earlier, but is that going to be skewed to international versus non-U.S. or any significant mix shift we should think about?

Well remember only about a quarter of our folks are in the U.S. so the sales is really pretty proportionate across the world in terms of increasing sales. In terms of -- you know, I would argue we do -- it's a challenge still to find R&D because, as Ken notes, I mean we do need people that have very specific expertise and so there we have really three primary locations but in the U.S., Canada, some in China but there again it's the challenge is finding people that have the expertise we need. But I don't think it's -- my sense right now is it will be the same relative proportions as it has been in the past in terms of U.S. and non-U.S.

Okay great and last question for me and I apologize if you mentioned this but did you disclose which revenue line item that the patent revenue is in?

Yes it's in the ratable and other.

It is. Okay terrific, thank you.

It's in ratable and other.

Got it, thanks.

Walter Pritchard, Citi.

Great thanks. Just on the -- where are we here? Just on the deals that you saw that were, that had unattached product sales, again, it was sort of asked here but any -- beyond MSP are there any verticals where you tend to see more of the firewall only type sales?

I am looking around the room. I don't know; no I don't think -- no I don't necessarily think there is anything specific there.

Okay got it and then just, as it relates to the rev rec change that you had all year, what's the anticipated benefit on a year-over-year basis in the fourth quarter?

Well, I -- you never quite -- you don't know if you what kind of deals you're going to do. You know, it's been running around $5 million the last couple quarters and so I don't have any better number than saying $5 million. I am looking around the room to see if anyone has any better number but my sense is roughly -- last couple quarters around $5 million so without having a scientist let's call it $5 million.

Okay got it and then I am just wondering if I look at what happened this quarter where your guidance, it looks like you were sort of -- we understand the inventory issue. You were maybe kind of middle, high end of the range of the billings guidance and the revenue guidance on the product side you were well in excess of where you were planning to be and I am wondering if you -- and it sounds like that had to do with the unattached appliance sales. And I am wondering as it relates to the guidance for Q4 what sort of assumptions you're planning on in terms of the mix there between -- I understand you've got a big renewal pipeline but around the unattached product sales and--

I think the rest of it is pretty -- it is probably right around the same. The big aspect is the renewals. We are expecting a lot more renewals in Q4 and obviously none of that will be recognizable in Q4.

Got it okay. All right, that's all I had. Thanks a lot.

Scott Zeller, Needham & Company.

Just, I guess you could call this housekeeping. In the past we have asked questions about the high end billings and this quarter I believe you said it was 37% of total and then you called out service providers at 28%, running around 25% to 30% typically. Are we to say then that the balance between the service provider number of 28% and the 37% is really "high end large enterprise" like that 9%? Is that the way we should look at these numbers?

Yes when you -- I was trying to think what 9% are you looking at?

Well, if there is 28% in the 3Q of billings attributed to service providers out of the 37% of billings.

Oh okay.

There are some minor (inaudible)--

Service provider is not all high end. That's the simple answer. That is not all high end because some MSSP, which is not high end necessarily.

Got it. In that case how then should we look? And I know you in the past you haven't given granular information but should we assume the balance at the high end between service provider and large enterprise was consistent this quarter?

I'm not sure I have that kind -- I don't have that kind of detail so yes I can't make a comment either way.

Okay thank you.

Dan Cummings, ThinkEquity.

I wanted to ask about the carrier vertical and I think in particular because we're perhaps seeing a little more appliance sales that have up front rev rec or more up front rev rec. relative to what Juniper was describing and recognizing that only a portion of your carrier business relates to capital spending at the carriers as opposed to the MSSP distribution, but are you at all concerned or have you factored in more caution in terms of a Telco's lean towards pushing business into next year perhaps in the 4Q relative to capital programs?

Yes we did point some caution and I do think -- I mean and I have read some of the reports on Juniper and relative to their doing high bookings but deferred, delayed billings if you will. So that's not quite -- we're not quite representative of that because of more of our business is of the MSSP but having said that, we are being somewhat cautious in that space as well.

Okay that's great and then on the financial services side could you characterize your opportunities I guess just maybe breaking FS down a little more by institutional markets, retail banking, insurance markets? Is this -- are these opportunities similar to what you see typically with your retail opportunities and your Telco business that really have kind of the full flavor of the product portfolio or is it more the high end chassis stuff?

This is Ken Xie. I think that from different market research the finance service market is about same size as the service provider telecom market but our percent is still relatively small compared what we have last quarter. We had about 28 from the service provider and it's about 9 comes from the finance service. One thing we see is really at (inaudible) there is relatively long and the some of that kind of more lesson to one market research firm than the others. We're kind of caught in the middle because even it's the same theme but it's two different market research firms called different terms so that's a part is really we also started building a team like almost one year ago so I think we're starting to see a lot of good deals starting ramping up.

It's that the key is really how to have the customer get hold of the product really starting to see the benefit of performance in itself so that's where they need a lot of sales to in the ground try to get a printout of the customer in hand and also see the benefit of it. I think that the sales cycle is relatively long but potentially I do see this finance service market is eventually probably about the same size and percentage as the service provider.

And the displacement, the work to actually achieve a displacement, that sounds very resource intensive as well. Do you suppose that those could come at a lower margin initially in order to really get in there and accepted?

It's probably not a margin because just like the high, they are mostly using a high end that's in the margin that I don't think the margins really will be lower than whatever. It's really how to get in, the same thing really some kind of finance service sector that the customer tends to be because some have switched and some of the security boxes also can be quite high cost on the management side so from time to time they prefer keeping whatever is being used and they also feel comfortable with the way they used the user interface in the past.

And so that's where it will take a little bit longer sales cycle there but we do have the benefit of additional function and also the performance so that's the same thing for them it's really after a few, every few years they need to replace the network box because the network goes faster and also there's more applications, more function in the Internet. They need it secure so that's where we try to kind of starting to engage and also but it's the sales cycle tends to be much longer compared with the enterprise and also the retail and some other space.

Okay thanks, Ken.

(Operator Instructions). Philip Rueppel, Wells Fargo Securities.

Great thanks and I know this is supposed to be focused on financial issues but I am really trying to get an idea of sort of the market opportunities for next generation firewalls and I know you addressed some of that in your earlier comments but it just seems like everybody, you guys, you know the traditional firewall vendors, the private companies, all seem to be touting this space as a next great opportunity. I was trying to get a perspective from you as to how much does that drive your potential for growth over the next few years? Is it just one other element of your UTM or is it a big new market?

Like I said, really the next gen firewall and the UTMs really come from two different market research firms. They do come (inaudible) charger since they don't like to use other firm's terms to really do their -- or their name, whatever the new trend. So that we're really launching the product in 2002 we converted integrated solutions of the whatever, the antivirus firewall, because since 2002 if you look at the products we launch we have a firewall. We have intrusion. We have antivirus VPN all integrated into a single platform.

And then in 2004 the IDC call it UTM but if you look at now the definition of next gen firewall is about the same. It's ready and also already in the last call I also mentioned the fact the intrusion now you can -- the application you can go the packet layer or you go to the full content layer so I think sometimes some firms just like to use some new terms to define the same thing but it's the key is really what's the function in there. What's the customer see that's different and that's where from the technical point of view I don't see anything different between the whether they're UTM or next gen firewall. Basically it's all integrated multiple function going to the content application layer trying to secure the content instead of the firewall just doing the connection, the access control.

So that's where the overall market we see just somehow the different firms using different terms that they don't like to use each other's, other firm's terms to name the things. I think that definitely the integrated, maybe just called integrated solutions, obviously whatever the terms it's the trend in the space because there's a much more function needs to be managed and also need to be going beyond the firewall so that's where the bigger trend.

Also that's where sometimes the intrusion gets in, the antivirus gets in and also the wide security needs to get in. Some of the applications controls, just part of the firewall function has been delivered for like many, many -- more than 10 years ago, because there is that already we see the virus goes through the permanent user, goes to the permanent application, is now embedded inside the content so just the firewall is no longer secure enough. So that's the reason we founded Fortinet but just sometimes the current market is little bit confused because there's a multiple term defining the same things.

Right and is application controls an area where sort of performance edge is increasingly important or is it something that point solutions can provide adequately?

I think application control from my point of view is really just one way to manage the firewall, just a part of the firewall. Sometimes the firewall you can manage by protocol. You can manage by the application of some user but it's the key is really that in the content side or like it's like most of the virus is all in fact that your unknown user or your friend sends you an email and there's a virus inside or whatever. They send with a page; there's a virus inside or intrusion spyware inside.

So that's where I see applications just how you want to set out the policy but in hand whatever any traffic comes in you still need to look in the content, both on the user application and also the inside, at the traffic. But it's nothing new. It's been there for more than 10 years and there's a lot of companies being used, just sometimes different companies they may emphasize something there. For us we're not trying to emphasize particular function because I feel all these functions are needed and just somehow how to manage and drawn forth so they're working together is more important instead of just marketing one or two functions, which could be -- make some splash in the market but in the end the users still need all the other functions making it working.

Great thanks. That's helpful.

Alan Weinfeld, Davis Securities.

Just getting back to the products that were really important in the billings in the quarter, you talked about a virtualization, which I guess might go along with the MSSP business with I guess the Telco providers but could you talk about how virtualization affected the quarter and how it fits in with the next generation firewall UTM, how you're using it?

Yes we can; Ken can talk about how we're using it. I don't think we can sort of ascribe any particular portion of this quarter to virtualization per se.

Yes I don't think it has really impacted the quarter but it's virtualization we study issues since 2004 basically really different for your customer or they can leverage one box or kind of crossing different box. We define it; it's called a virtual domain so that's where a customer can define their own policy, let these relatively independent about how or especially the service provider likes it because they need to have the feasibility to really depend on the hundreds of thousands customers they serve. It's -- I don't see it's impacted the quarter. It's been we are doing that for the last like seven, eight years.

So you basically obviously don't have any data centers of your own but you basically can move your equipment into the service providers' data center and obviously you get extremely high speeds with extremely security.

Yes there most go to the service provider. Now there are some data center come out but it's still remote kind of working with the service provider to provide a service, most of the telecom service providers also.

And there's been some talk. I don't know if you had seen any but in the last month of the government fiscal year that ended September 30th did you see any extra spending by the government on security, maybe possibly of kind of government budget flush since they were so tight with spending on supposedly everything during the year? And do you foresee a looser spending environment for fiscal '12 that started October 1st, at least at the Federal government in the United States?

The Federal government is still one of our small percentage of our business and even we have all the specification. We have all the commentary. I think we have the highest level of [content] certification there but it's we still need to keep improving but so far it's not a big part of our business compared to some of our competitors. We don't -- I think there are a few delays of the approval of the budget in September but overall I think it's probably more our own execution. We need to do a better job there and the same ties, that's also the space we probably need to invest more going forward so that's the two comments I have.

We have to move on. I think we only have time for one or two more questions.

Thanks.

Michael Turits, Raymond James.

It's just a quick question. I noticed in the footnote that you had actually backed out the patent income from non-GAAP so just a consistency question; how come you backed out the income but keep in the rest?

No everything is GAAP and non-GAAP. Everything is in the patent; some is in GAAP and non-GAAP, of the patent sale yes. Of the patent sale that we did, $2.6 million, all of that's in GAAP and non-GAAP.

Okay my -- it looked in the footnote to me like you were backing it out of non-GAAP.

No, no, no.

Okay thanks.

That was the -- where you're looking at it as a settlement, it gets a little confusing. When we did a settlement about a year ago we did that; because that was a legal settlement that was excluded but that's different than the patent sale.

Got it, perfect, my confusion. Thanks.

Yes it is a little confusing too but the settlement was backed out. The patent sale is inclusive in GAAP and non-GAAP.

Okay and but is there any reason why the income is not -- is that all straight income, the revenue equals the income on the patent?

Correct.

Thanks.

[Jacob Schulman], Oppenheimer.

Hey, guys, great quarter. Just a question about ratable services and regarding the patent, how should we think about ratable services going into next year?

Well, the ratable services from the preexisting revenues we -- deferred revenue we incurred, that pretty much is over in another year and a half, two years, pretty much. It means a little bit in tail on that. There is some revenue we get, which is -- is it how much per quarter do we get on the -- 250 yes. We get 250 and that was for a total of three years and so I think we have about two more years on that, which is 250 per quarter.

Great. Thanks, guys.

Thank you and that does conclude our time for questions and answers. I'd like to turn the program back over to management for any closing remarks.

Management just thanks you for bearing with us and pre World Series game on and so I won't ask anyone for their favorites but nonetheless thank you for being on this call and I am sure we'll see various -- many of you at various conferences and so forth along the way. So thanks again for listening in to our two calls. I appreciate it.

Thank you, sir. Ladies and gentlemen, this does conclude today's program. Thank you for your participation and have a wonderful day. Attendees, you may disconnect at this time.