Fortinet Inc (FTNT) 2013 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to your Fortinet Q3 2013 earnings financial analyst Q&A. At this time, all participants will be in a listen-only mode, but later there will be a question-and-answer session and instructions will be given at that time. (Operator Instructions). As a reminder, today's conference is being recorded.

And now, I would like to turn it over to your host, Michelle Spolver.

Hi, everybody. Thank you for joining today's call. Nice to talk to you again.

As you know, the purpose of the second call is to answer any more detailed questions that you have after you have had a chance to assess our financial results.

And also as a reminder, the forward-looking statement disclaimer that I made at the beginning of the call earlier today applies to all forward-looking statements we make in this Q&A call.

So with that, Operator, we can open it up to Q&A. And with me, I should say, is Ahmed Rubaie and Ken Xie.

(Operator Instructions). Jonathan Ho, William Blair.

Just wanted to understand a little bit. We were under the impression that the US government was not really a large part of the government vertical. Could you talk a little bit more in terms of color relative to the US government shutdown, how that impacts your business? Is this more sort of an indirect impact on your customers or for state funding? Just want to get a sense of how you are thinking about that.

Good question, Jonathan, and you are correct on both counts, meaning that it is not a large part of our business. The commentary that I was making is more in the context of how this impacts buying behavior across the board and particularly in the larger enterprise. So it's not federal government specific; it's buying behavior specific across the board.

Got it, got it. And just to dig a little bit into what's been happening in the APAC region, do you guys have currency translation exposure or is this more of a hit to the budget? Just wanted to understand how you're pricing in the regions that are maybe seeing a little bit of currency impact?

Yes, the majority of our business is done in US dollar currency, so it's not really much of a currency impact. This is primarily spending behavior across the region.

Got it.

(multiple speakers) impact our channel partner a little bit.

Yes, the buying behavior.

The buying behavior, yes, and buying power, purchasing power is impacted, but it's an indirect impact.

Yes, worldwide we all sell in US dollar, but they are selling toward local currency to their customer. So currency change will impact the channel, not us.

Got it. Got it.

So there's nothing on our financials, but at the end of the day, it does impact buying behavior. If it's more expensive today because of currency, then you're going to think twice.

Right, it's the equivalent of shrinking their budget by 25% or whatever the inflationary amount is.

Or stalling it. Yes.

You are shrinking your margin some time. Or expand their margin, depending on which way the currency go.

Got it. And then, relative to the service provider market, you guys have talked about this 4G/LTE opportunity, but I wanted to understand this. Is this just a large packet filter that you're going to be selling or is this -- I think you guys have done some deals in the past where it has been large firewalls, or is this going to be the full services offering across those networks? Just wanted to get a sense of what is being sold and what the use case is on those 4G/LTE networks.

Yes, I think there is a few things different in the 4G [wireless] more high speed, because definitely the network speed go faster and faster each new generation.

And then, the second part is really a lot of small packet. You have to deal with a large number of concurrent session, a new session, and also they prefer to manage device individually, whether because the [bio did] because all these device -- smart device, the study has a lot of security concern. So that is why the need to secure the 4G/LTE.

The gateway requirement is a lot higher compared to the traditional firewall, so we believe the FortiGate platform is the new ASIC, and also both the function and the architecture performance feed well for the 4G/LTE trend.

Got it. I will yield the floor. Thank you.

Nandan Amladi, Deutsche Bank.

I was actually queued up on the main call, but I got disconnected somehow. So Ken, you talked about the new single-chip ASIC design that you are launching, I think, next year. How does that change the competitive dynamic? Will your focus remain the price-performance ratio or does it change other attributes of the physical design -- power consumption, footprint, anything like that?

I mentioned there is three ASIC family. The one I just said in this earnings call is the MP6. The network processor is up high, to the high end, and also some middle-range product to improving the packet process per second, and also the latency and some other small packet function and especially the network-related firewall VPN function.

And then, so that -- the MP processor actually improved the ease and efficiency of the PC architecture, the system architecture, a lot of the PC kind of services that it had. And then, the one -- we announced one year ago the SOC chip. It's really improving on the low end because you can put a lot of function into a single-chip, compared to a lot of competitors. You have to use a small computer to do -- to secure the gateway function, so that's also helping a lot on the price performance wise.

And then, the other one we are going to release in the next year is we call the content processor is the co-processor next to the CPU, because CPU is not designed to run a lot of network security function, so the content processor is really helping accelerate a lot of function by 10X to 100X. So that's a lot of huge improvement.

I think we are remodeling this architecture, changing both in how we are in the multifunction, like certainly this Company and also if you're copying my previous company, almost 20 years, because we still believe we're the only one who solve the gateway problem both on the software multifunction and also the hardware architecture ASIC level.

So eventually, this will be -- have a huge performance and huge advantage compared to some other software-based general-purpose processor solution put on as a network security gateway. So that is the chip.

It will be more technical, more complicated, but it's an investment we made in the last 10, 20 years starting to show some huge advantage over some of our current competitors' solution. Also because the market changing the trend, it will be more multifunction integrated together, and you're taking the high-speed environment and also need to move the security function to the higher layer.

Okay, thank you. And then, one other question for Ahmed, if I might. You discussed some of the larger contracts and the success you have had at the high end of the market with both enterprises and service providers. But you cautioned us not to make that a trend. Obviously, there is probably a little hint of caution there for us not to get too excited, but where are your sales efforts being? Are they being redirected in any way or are you still fairly evenly spread out across the three major segments you have?

I think we are pretty diversified and spread out, not only in terms of those segments, but across the globe.

I think the reason I am cautioning us, including myself, internally, is because of the continued change in the macro dynamic, and what buying behavior will translate in Q4 is anybody's guess. So based on what I see today, I am optimistic about our ability to execute, and we will continue to improve upon it across the board, but I can't control the macro.

Yes, no, that's fair. And if I have time for one really quick one, on the competitive wins, you talked a lot about Cisco and Juniper and Palo Alto, but I might have missed it, did you mention wins against Check Point as well, and what is your win rate doing with that particular competitor?

Yes, we mentioned Check Point, actually, several times on specific deals. Michelle can give you specific references from the transcript, but from memory, at least three or four times. In terms of win/loss rate, we don't actually disclose that.

Okay, well, thank you.

But needless to say, we did.

Thank you very much.

Gregg Moskowitz, Cowen and Company.

Ahmed, you gave some color on the service provider vertical, which was helpful. Just wondering, though, how you would characterize the behavior from MSSPs, in particular, this past quarter?

Yes, I think if you look across the board, not just my commentary, but across others, I think people were hoping for a bigger return out of the MSSPs in Q3, and it was mixed across the board.

For us, it was in line with our expectations, but as you can tell, I am cautiously optimistic as we go forward. So I wouldn't call anything a trend just yet, in terms of the MSSP overall spend coming back at full speed.

Okay, and were there any specific areas of strength or weakness in Europe that you would call out in the Q3?

No, I think as I pointed out, I think the Middle East did well for us, as part of EMEA. I think certain parts of Europe did a very good job in terms of execution, but I really look at Europe as no change from the last quarter. And so, there really is trend to spell out.

Okay, and then maybe just one last one, Ahmed, have there been -- or for Ken -- have there been any competitive changes over the past two months? I know you guys have talked -- answered the competition question. Just kind of wondering if you splice it by high end, by mid-market, if there is anything that you would point out there or is it pretty much status quo?

It is status quo, and it's business as usual. They are all formidable competitors. They win some; we win some. So beyond what we have already commented, there is nothing further.

Okay, great. Thanks very much.

Sterling Auty, JPMorgan.

I apologize if you covered some of this; we're jumping around between calls, but with the release of a new network processor, Ken, I wondered if you could give a sense in terms of what kind of yields that you're getting on it. Because I know -- I think initially when you come out with a new processor, the cost starts at a level, but then you gain scale as you move forward. I am wondering how this generation looks versus the last generation.

I think the yield is pretty good because the chip itself still a small part of cost of the overall system, and also we mentioned about it is more helping improving the performance, the latency, the power consumption, and also, the chip's cost is also probably only like 10% or less of the general-purpose processor cost.

So that's where -- the yield is not a big issue that way, because once we design a chip, it is also -- it is all working fine. It also take about -- almost two to three years to design each generation of chip, so it's a [duanot] process. There is a lot of -- from the beta to the simulation, all this kind of thing. So I think it will be -- it is not a concern, because when we announced the chip, just like we announced the system, is all proven, working well.

Okay, and then --

(multiple speakers) shipping -- and started shipping and also starting using the chip in the new system.

Okay, great. Then on a different topic, looking at the billings mix and looking at the high end where it's 40% versus 36% in the previous year, how much of that is ground that you're gaining that you started last year with getting into the actual telco data center, and how much of that is actually implementations in enterprise data centers?

Because enterprise really more focused on buying some high end, that maybe helps some. We don't track the detail, and also, the chip going forward will help in both on the high end, also in the middle range -- I mean, the MP6 chip.

Within the -- when we track the models, we don't go deeper than that and assign it for high-end enterprise versus telco versus MSSP, but those are the three groups that would buy the high-end systems.

(multiple speakers)

I just didn't --

Yes, you are trying to ascertain how much traction in the high-end enterprise is leading to that, the growth mix. The growth in the mix, right?

Exactly. Even if it's qualitative, because I know that you started to see those data center wins in telco starting in 2012 carried into this year. I didn't know if that was just the continued momentum or if you were starting to see enterprise data center wins based on performance, as well?

We are starting to see more, and it's not something that is unique in Q3. We have been seeing it, solely over the last few quarters, the increased traction in enterprise data center. A good sort of thing to look at is when we talk about the deals won during the quarter, and then also our large deals, large deal sizes, if it is a data center deployment, it tends to fall in the large deal category.

Got you. Thank you.

James Wesman, Raymond James.

First, I want to piggyback on Gregg's question a little bit. Taking a look, Check Point had said on their call, they had been noticeably more aggressive in the low end of the market. I was just wondering what you guys have seen in the low end of the market versus them in terms of entry-level appliances. From a competitive standpoint? Are you seeing them in deals, et cetera?

We somehow, we not quite see much competition from Check Point in the low end yet, but it's also because some of the new product we launched in Q3 starting improving the price performance in low end a lot. So far, maybe because other competitor even weaker, but we had a real nice low-end channel growth in last quarter.

Yes, we talked about in Q2 we had very good channel growth. We had good growth in Q3 as well, and if you look at the product segmentation slide, which is the mix of products that are sold during the quarter, the entry-level group, which is sold to SMBs and also enterprise branch offices, but a good portion to SMBs, was 40%. And that grew -- that is 4% higher than it was a year ago this time.

So there is -- I think we are doing really well still in the SMB.

Great, and then, just a follow-up on the inventory build that Ahmed had spoken about earlier. Why was it bigger this quarter than you had thought? I believe last quarter you guys had lowered the free cash flow guide in anticipation of an inventory build. And I noticed that you did lower it again. Why was it bigger than you thought, and I guess on the pipeline, does that mean that the pipe is materially larger than you thought last quarter?

So I think the point is to take the context of what I said, and that is halfway through the quarter, what we saw in the pipeline then, plus the launch of new products that were going to happen and they did happen, and there was also a holiday in China the first week of October and that's where our contract manufacturers are, so it's a balance of all those things. We said let's load up for the rest of the year.

But it's not a reflection today on the Q4 pipeline. It was several weeks ago when we did it, and the point I made is at the end of the day, I still feel very good. If you were to just focus on inventory, we will finish up somewhere in the midpoint, probably between 2 to 3 turns at the end of the December quarter. So there's nothing more to it than that.

Great, and then just one last housekeeping question, Ahmed. Cash tax for 2013 and 2014, any expectations you have for the rate?

In terms of the non-GAAP rate, I would expect it to be the same, in the 33%, 34%. In terms of next year, you will have to forgive me. I haven't done the plan for next year. But I know of nothing today that would suggest something materially different.

Okay, and then, any thoughts for 2013 cash tax?

Cash tax in total, you mean?

Yes.

I don't -- probably somewhere -- what would you say, Michelle, about 25 to 28, give or take?

25.

Yes, about 25 to -- if you want a more precise answer, we can follow up after the call.

All right, I appreciate it. Thanks, guys.

Keith Weiss, Morgan Stanley.

This is Melissa Gorham calling for Keith Weiss. Thanks for taking my question. Just have a quick question on CapEx. Last quarter, you mentioned $10 million to $12 million in CapEx spending, I think, for the second half of the year, for the construction of a new building. Is that still the plan, and how much are we already through that spending in 3Q, and what should we expect for Q4?

Yes, I don't think I mentioned $10 million to $12 million for the current year. I think I said by the time the building is done next year at the end of the March quarter, it will be $20 million in total.

And in terms of the current year, we are tracking to our spend levels on the building. It's progressing. We have got permits done. We are moving forward.

Okay, got it. And then, question for Ken. Some of the load-balancing guys, like F5, have been talking about getting more competitive in the security space. Do you see them at all and are they a real competitive threat at this point?

I think they are more focused in the data center, while we are more in the enterprise level, and we're not quite compete with them directly right now.

Okay, got it. Thank you.

Walter Pritchard, Citi.

Just one further clarification on the service provider side. I'm wondering if indeed you have seen the purchasing behavior of them having gone to smaller purchases, as opposed to bigger upfront buys, if that's normalized at this point, and where it's normalized, at what type of activity?

Walter, I don't think we can declare a trend just yet in terms of what's normalized. I think we are seeing a mixed bag. We talked about a very large deal in a Fortune 200 already existing customer. So clearly, they had the appetite to write a big check.

And then, we saw a bunch of other deals that made up the quarter. So I still think it's too early to say the buying behavior of service providers, both in terms of MSSP, as well as the direly needed change to 4G/LTE and 100 gigabyte, et cetera, is a trend now. It's too early.

And then, Ken, just for you on the MPU rollout, can you give us a sense of -- it does appear as though that product, your high-end product that's being refreshed, has had an impact on your business, and I guess we expected coming into the year that you might see this type of impact. It looks like you are starting to see it here in the second half.

Can you talk about how you expect to see the MPU rolled out through your product line, and what sort of impact did that have on Q3 and what impact do you expect that rollout through the rest of the product line to have in the coming quarters?

I think even in the next few quarters, we are starting to build in MP6 into the new system, just like we really announced SOC 2, the system chip version 2, one year ago. It take a few quarter to start building in the system.

So because we don't sell in a chip directly, so the impact will be more long term, give more advantage over competitor on the system, on the hardware side. The software is always the same, but when there is new hardware running the same software, there is a huge improvement on the performance and also helping on the function, also.

I say it will be a few quarter gradually helping improving and make us more better, more advantaged over the competitor products.

Walter, I think the best way to look at it -- Ken is spot on -- is at the end of the day for us, for the Fortinet story, it's an enabler of continued escalated growth, versus a certain refresh that is going to have an impact, a material impact, whether on -- to your question on Q3 or any other time.

So it's beginning to roll out now. It will be part of our growth as we go forward over the next several quarters. The more important point that Ken highlighted during his script is customers are pretty excited because it is faster performance and much lower latency, and so the cost is much lower on a performance basis.

And finally, actually, Walter, you had asked, I think, in the beginning what kind of impact, if any, in Q3 did the product have. It wasn't announced until early October, so no impact to Q3 at all.

Okay (multiple speakers). Sorry, go ahead, Michelle.

I was going to say, because even though the chip was ready and had to be -- the first model product that was integrating the chip was announced in October.

Okay, got it. And then, just last question for Ahmed on cash taxes. I think it was asked about 2013. I realize you're not giving overall 2014 guidance, but directionally, could you help us understand what you expect out of cash taxes going into next year?

To be honest, beyond what I know for the current year, I can't give you any further advice on that.

In other words, I would expect it to be in a similar range as the current year, but I haven't done my billings and P&L, so I don't know what next year is going to look like, and that drives the cash tax payments, as you know.

Okay, all right. We will wait to hear that. Thank you.

I think for modeling just use the non-GAAP rate until we come out with guidance for next year.

Okay, fair enough.

(Operator Instructions). Catharine Trebnick, Northland Securities.

Thanks for taking my question, and I am sorry if one of them is repeated. On the carrier market, what I am trying to understand is the sellthrough versus the managed services. Like Verizon just announced their 21% year-over-year decline in CP sellthrough, but managed services was up. So can you talk to or give us some background or color on overall in the MSSP market, how this plays out with your channel? Thanks.

Sure, so I think for us, the bulk of our business is selling through. We also have a part of our business that caters to the service providers themselves.

I can't comment on Verizon's specifics. I can tell you what we see across the globe and across service providers, and that is in terms of the sellthrough, it was an in-line quarter for us across the globe. In terms of selling to the service providers, we had a very large deal in a Fortune 200 service provider. But we are not yet calling any of this a trend. We're walking into Q4 cautiously optimistic.

Okay, thank you.

Thank you, and I am showing no further questions in the queue. I would like to turn the conference back to your host for any concluding remarks.

No more concluding remarks, other than thank you for your time. I know it was a busy day with other calls, so thanks for your time. And in terms of -- I am available for follow-up questions; in terms of conferences, it's lighter activity this quarter, but we will be out there at some conferences and in front of investors, of course. So thanks a lot.

Take care.

Thank you. Ladies and gentlemen, this does conclude you conference. You may now disconnect and have a great day.