Fortinet Inc (FTNT) 2013 Q4 法說會逐字稿

Good day, ladies and gentlemen, and welcome to your Fortinet Q4 2013 earnings financial analyst Q&A. At this time, all participants will be in a listen-only mode, but later there will be a chance to ask questions, and instructions will be given at that time.

(Operator Instructions)

And as a reminder, today's conference is being recorded. And now, I would like to turn it over to your host, Drew Del Matto.

Thank you, and thank you for joining us again, Ken and Michelle are with me here in our room at Fortinet. Before we get started, I'd like to note that all forward-looking statements made during this second call are subject to Michelle's early comments on the prior call. With that, I'll start the Q&A.

(Operator Instructions)

Keith Weiss, Morgan Stanley.

This is Melissa again, for Keith. This question is for Ken. I'm just wondering, the improvement in growth in the quarter, how much do you think that is related to an improving macro versus just the improvement in execution on Fortinet's part?

I think there's both improvement. It's difficult to quantify that.

But I think definitely have a higher demand early of the new year helping on the growth. And also I mentioned the inventory, also we have a better inventory control now, and that has also helped.

In the micro, we can see that the service provider also relatively better, but also we see quite a strong under price in some other sector as well. Also, Europe, we all see probably not only Fortinet, but also some other companies starting to doing better in some local areas that we also have some experience.

That's pretty much all the contribution. It's difficult to see how much specific comes from internal, how much comes from outside. I'm not sure, Drew or Michelle you have anything?

That's fine.

Yes. As far as operations.

Okay. Great.

And one question for Andrew. On cash flow for Q1, you mentioned two one-time items, the one being higher tax and then the other, the building CapEx. Just wondering if you can clarify the magnitude of the tax payment again. I know you said it, but I missed it.

And then aside from those two one-time items, do you foresee anything else in 2014 that would be one time that would impact cash flow?

Sure, Melissa. The first, I think we said $18 million to $21 million on the tax item. And then the other thing we flagged, which was probably --

Again, we're not giving FY14 guidance, but we did flag the ERP, the fact that we're actually going to start building out, filling the Company's back-office which means new ERP. And so that at some point, that we'll have some impact, and we can see some minimal impact to that in Q1. And again, not to get into FY14 guidance, but that was just more heads up that there could be some impact there longer-term.

And the building cost was about estimated about $10 million.

And that's all just in Q1?

Yes.

Okay. All right. Great. Thank you.

Jayson Noland, Robert Baird.

Just to follow up on the CapEx, Drew, can you bracket that for the full year at all? $25 million, $30 million, is that how we should think of the CapEx number for FY14, or hard to do at this point?

I think hard to do at this point, Jayson.

Okay. Question on hiring. It's a pretty aggressive ramp. Are those people mostly already on board? Or are you still out looking, and how have those hires gone?

Where are you finding people? Any additional color there?

We more aggressively added on last year. You can see income growth quarter by quarter. And then Q4 is -- compared to earlier in the year we slowed a little bit, but I believe with the micro growth, the data center, service provider, certain enterprise, vertical market. We probably were starting hiring, but it's also like I say, probably not quite as aggressive as we did years ago, but probably still keeping hiring growth.

We've got to make sure it all fits better because as I say, early -- like first three after the IPO, high count growth is probably half or less than half of the top line growth, which, starting to pay some tax in the last one or two years, because it's -- whether the service part or some other sales coverage part is falling behind. Now we're starting to see the benefit, especially I mentioned in Latin America and Canada, where we hired some people about a year ago, we see much better growth. So we're keeping hiring, but also consider we need to hold things together, we're not aggressive hiring, but also more reasonable keep hiring, enough growth in sync.

It sounds like a lot of these new sales hires are focused on large accounts, as opposed to regions or territories. Is that a fair assumption?

I don't mean the channel, in some area we have a good coverage. Some of the vertical space, and also some of the certain bigger data center, or something -- that we see would be a good potential, so we probably need hands in that area.

I think that's in the future. If you look back in 2013, it was spread out across the board, really. There was a focus on enterprise and large accounts, but for the territory standpoint or a geography standpoint, we made reference before.

We also did a lot to beef up our Latin America team, and had a lot of hires there, too. So it's a little bit of both, but with a focus on growing enterprise.

Great. Thank you.

James Westman, Raymond James.

So, some of the comments, I know you're not giving for 2014 guidance but I want to make sure I understood some of them. I think you commented something about being able at some point to grow twice the industry rate, which I think you said was 6.5% to 7%. Does that mean you're only targeting 13% to 14% revenue growth for 2014?

We're talking about -- right now currently, it's 6% to 7.5% so the opposite of what you had said, 6% to 7.5%. IDC has it at 6%, Gartner has it at 7.5%. We did make a statement that we think that those numbers are a bit conservative.

Don't know exactly how conservative it is, but based on, I think, where the market is right now, they're probably a little conservative, because again, remember that was -- the entire market got cut last year. That was a slowdown there.

Also the market is fairly big, the total security appliance is about $10 billion market size, so that's a market we operate in from that point on.

Michael, to your point, I think you're saying so, is that what guidance is? Is it 12% to 15%? So we're not giving guidance. So it's hard, but we did want to give you some sort of a sense of what our goals are here for the year.

So I would say again, our goal is to outgrow the market by 2% or better. Where that market is growing right now, that doesn't --

Okay. And then on margins, you did 19% margins in 2013? And you're talking about 17% margins for 2014? Is that right?

Yes. We said 17% plus or minus a point on an annualized basis.

Annualized, meaning full year?

Even James, just to say that, you are trying to get some level of direction. More aspirationally at this point, again, as I said, we're going to take some time to go look at where we really should set the bar.

I'm just trying to give some sense of where we see the lower side of it. I think would be the way to characterize it, hopefully. In the 17% to plus or minus 1% range.

So you think the floor --

We're not trying to set annual guidance for that number, quite frankly. We're just trying to give people a sense.

Right. You said that's what you think the floor might be? Again, I'm sorry to ask it, but it's a big cut you're talking about, 2 points of margin compression in the next year or so, I want to make sure I understand what you're trying to message.

Yes. Like I said -- the problem is, I understand what you're trying to do, Michael. You have a not a model you need to build for a year, and we're giving you quarterly guidance.

We could say nothing over the year or we could say something, so we're trying to give you a sense. So 17%, what we're saying is 17% plus or minus. It could be 18% or it could be 16%, it will be somewhere in that range.

And again I know you've talked about it and I appreciate -- if you talked -- just to really focus in on the three drivers of that margin compression? So what are the big spending areas that drive that?

Sure. Again, it's really investment in sales and marketing, primarily. On the sales side, we're expanding and improving our sales teams across geographies and verticals.

It's just what Ken just answered, just a minute ago. I think Jayson asked the question for that.

Marketing, we're also investing just the general marketing and lead generation. Really to improve the overall productivity in the sales force but that takes some upfront investment in the near-term so we're accounting for that. There's a little bit of investment in R&D for new products and introductions.

I don't think I mentioned this before, but there's actually a little bit of investment and support. Our customer base is growing, so we need to make sure that we scale with that. And then I think the final thing I said on -- was just some investment in G&A, as well, just as we scale the back-office part of the business, to keep up with the growth of the Company, and be ready for the next level.

If you could if I could ask a few more, now to move on to free cash flow, so you talked about an incremental 1Q tax payment of $18 million to $20 million. So that's not all cash taxes or is that $18 million to $20 million more than previous?

It's all cash taxes.

That's your full cash tax payments? That's what you're paying in cash?

For that quarter, for Q1.

And what was it -- what's the run rate? In other words, what's the change here?

I would think -- what I would be willing to do here is, I think from a non-GAAP perspective, I know that's not the question, but I'm going to start here, probably the right rate to model for now is 33%. I think that's been the rate in the past.

We have -- what's driving the tax rate is actually that there's been a -- there's going to be a jurisdictional shift in income, which will ultimately bring tax rates down lower, later. We probably won't see that benefit in the next year, unfortunately.

What drove it a little higher in Q4 was the fact that the estimates included a higher kind of income offshore, if you will, or higher at a lower text jurisdiction, and that just didn't happen as quickly as originally anticipated. And so that drives a little higher tax near-term. But longer-term it offsets into a more beneficial tax rate, but we won't see that probably in 2014.

Cash flow is just really important here, so as I said, I just need to understand the cash tax.

It's difficult.

What would typically -- I guess I could go back to my model, and back into what we were, but what are you saying about Q1 cash taxes relative to the run rates? So what would you have expected it to be?

How much is it higher and for what reason? And is that a one-time are for this quarter, or is that the run rate for the year?

My understanding, James, is that we paid about $25 million last year, and since that was roughly $6 million a quarter, so maybe it goes up a little bit with the income. There was probably an increment of 10% to 12% in there, something like that. If I'm doing my math right, 11% to 12%.

Right. So $25 million --

Due to the issue -- I'm sorry?

It was $25 million last year for all of cash tax?

Yes.

So is this boost from a $6 million run rate to $18 million to $21 million is that a one-time or is that --

We believe it's a one-timer, but again, we're not giving forward guidance other than on the non-tax -- on the non-GAAP tax rate.

Okay.

We don't anticipate seeing it again, I would say that.

So it goes back to the $6 million run rate after that?

Yes. Or -- again you have to account for higher income. Over time. That's what happened.

Okay. $6 million then. Whatever. Growth from last year.

Got it.

Okay. Thank you.

Gregg Moskowitz, Cowen.

Just a very quick follow-up to Michael's question. So, in terms of the $25 million, Drew, that was paid in 2013, it sounds like that will go up by around, give or take $15 million or so in 2014, is that roughly the right way to think about it? In other words, it will be $18 million to $21 million for Q1, and assume a normalized run rate in Q2 through Q4?

It's off a higher income base. So --

Yes. I think so.

I'll tell you what. Gregg, I'm going to follow up on that question, but that is the way we're thinking about it. I want to make sure we have that right, though.

Okay. Perfect.

And maybe we can follow-up in the next 20 minutes or so with you.

Okay. Perfect. Thanks, Drew.

Ken, enterprise spending rebounded for you in Q3, and certainly continued into the Q4 as well. Just wondering if you could elaborate on your investment here. And really, if you had any proof points of how that might be starting to resonate with customers?

In the enterprise space we don't have enough coverage, like the US in the past. So that's an area we are going to improve in, both by additional sales force, also by [dilution].

So we see a pretty good return once we have the sales force covered ultimately. So that's the area we think we're going to improve in, especially in the US enterprise, in this year.

Okay. And then Ken, do you have any thoughts -- there's been a lot of talk around the network refresh just in terms of when one might occur and what that could mean for Fortinet and the industry overall as well?

I think, like I said, there's a few trials for the network refresh. In enterprise, definitely we see the higher, like 40 gig, 100 gig would be driving that, and that, especially data center probably 40 gigs mature enough.

The 100 gig, still a lot of solution, not quite mature or stable enough. So I think it's probably towards the middle of the year that things will be much better shape, so that's where we will see probably something -- maybe starting, like in Q2, Q3 whatever. We'll see the data center solution starting more mature in the 100 gig level.

The carrier is taking a relatively long time, also they are -- carrier also really have the annual budget planning, so we see a lot of tightening going on, and also a lot of opportunity to secure the mobile data carrier. So that's probably where -- I imagine that maybe we'll do better than last year, and probably not jump that quick as in data center, to have more opportunity.

Okay. That's helpful. And then one last one if I could, wondering if you could talk about the FortiSandbox-3000D, just in terms how that compares to dedicated solutions that try to protect against APTs? And going forward, do you expect more customer deployments as a stand-alone on premise appliance, or integrated with FortiGate and FortiMail?

We do have a sense of integrating FortiGate already, but also the dedicated box, also a lot of deployment and also the new dedicated box combined is the primary firewall and also the e-mail solution together. So I think the big box, we try to put behind firewall for extra layer of protection, and then the FortiGate has relatively small, but it's a more realtime sandbox function, which has been there for many years already.

That's where the test we mentioned on the earnings call is really going to detect all these we call these proactive detection -- you don't have signature, you also cannot get any update off the box. We need to catch the malware in the back there, so that will take quite a wall. Like I said the sandbox -- in the firewall has to do a lot of realtime protection, compared to some kind of sandbox, it may take some extra delay, and to do some extra check, but it's really the hypermodel combination. For the big enterprise sometimes they have additional dedicated sandbox but for a lot enterprise, they probably will depend on the firewall to do the job.

Okay. Thank you very much.

Can I follow-up on -- this is Drew, I do have an answer on the tax question. So just to go back, we have the answer in front of us. Wanted to make sure before I asked, if you were modeling 35%, I think you'd be right in the range.

We would call it somewhere between 32% and 36%, let's say. Depending on a couple factors, but so yes, probably 7% to 10% incremental year-over-year.

Perfect. Thanks, Drew.

Andrew Tisch, Jefferies.

This is Andrew here for Aaron. Just a real quick question, when you talk about double the market growth rates, are you talking about billings or revenue?

Billings.

Okay. That's it. Thanks.

James Fish, Citi.

Just wanted to get some more detail and clarification on, I believe you said that new products were a driver this quarter for you. Some commentary around that as to why that was, as past years it wasn't as much?

I'll let Ken elaborate. I don't know if I would say it was not as much.

We definitely had quarters in the past whether it's typically around new ASICs will tend to drive some business, but I don't know -- I do know that it wasn't anything more significant than what we would normally see. New products do tend to drive business, because it tends to be a more competitive offering in the market.

That's probably like last quarter or this quarter will be the same as the previous quarter. No big difference, because once we have the new chip every quarter -- each quarter we have a few products come out, leverage new chip, new solutions. So we'll be mostly for the new product use in the new chip new technology. Not a big change from the previous pattern.

Right.

So I'm trying to get a clarification here. Is it more the pickup then, in customer demand, or was it more new products coming in the line that's really helped you this quarter then?

The product would be, like I said, really the same as --

I think, between the two, it's the pickup of the customer demand across-the-board. So definitely we saw additional interest in new products. That wasn't what drove everything during the quarter.

There's demand across our product line. Some of the new products were met well, but I would look at it more of just demand across.

Okay, great, thanks. That definitely helps a bit more.

And then probably for Drew, with the sales and marketing spend, I know you're talking about, and we've had numerous questions here on the operating margins, and the fact that they're going to be about 12% is what you guided to, for Q1. What kind of ramp should we expect deceleration in sales and marketing spend throughout the year, and is that going to be more across a couple of years that we should expect high sales growth? Or is it going to dwindle down as normal?

I really don't have a lot to add to what we've already discussed. We're giving Q1 guidance and that's a 12% operating margin we discussed.

I think for the year we talked about 17% on an annualized basis. Plus or minus a point as what we hoped at the lower end. But I really don't have a lot more to add, other than qualitatively what we're investing in, which I think we have discussed.

Yes. Understood. Thank you very much.

(Operator Instructions)

John Lucia, JMP Securities.

Given the investments you'll be making in sales and marketing, what are you doing to improve your channel relations, and improve your mind share in the channel?

We commit to be the channel company and the offering is from the channel. So that's -- in the channel conference we have about 1,000 channel partners attend the conference earlier this month -- it's like I said they are all very excited about opportunities both in the market and the new product. We have 100% support in the channel. And the one sales and marketing we're hiring, we called it direct touch but we still go to the channel, pull from the channel, and also supporting the channel together.

Let me add a little bit there. Certainly we're always looking to improve, so I don't want to say that there's no improvement there, but I will say that we do actually have good channel relations.

We have traditionally or typically been recognized, even last year as best vendor in the security category by Everything Channel which is sort of like the big channel award there. And it measures channel satisfaction, on the way of partnership, profit margins, and product line. So again, I don't want to imply that we have bad channel relations. We're always looking to improve a bit, but we're pretty pleased with where they are at.

The other thing in terms of what else are we doing? So one area that we are putting some attention in is expanding and deepening our relationships, with what we call national retailers, which are the larger channel partners that are very focused on enterprise.

We have those partnerships today. We're looking to put a little bit more focus and investment behind that, as well.

And the investments you made earlier in the year, did that lead to any better channel execution in this quarter? Is that what contributed to the strength, or is that just overall demand?

No. It's overall demand. Q4, we did talk about, I believe it was either Q3 or Q2, we had a really, really great strong channel quarter, and part of it was because we had put investment into the channel.

I think Q4 was more across-the-board with more strength in -- yes. Channel did well, but it didn't make our quarter, basically.

Okay. I have one more question. Given the attacks on Target and Neiman Marcus and the like, are you expecting any change to the regulatory environment for cyber security in FY14?

I hope what we experience in other security, in that space, retail whatever, but we did see during the trade show earlier this month, we did see more strong like demand in the retail space to be more secure. Especially online transaction or these kind of things.

So we see there's good potential there. But regulatory, hard to say.

Okay. So no comments on regulatory environment but you think that demand will be strong in FY14?

Yes.

Okay. All right. That's it for me. Thank you.

David Kaplan, Barclays.

A little bit of a follow-on to that last question. Also, in terms of the types of products that you see out there, both from the new products that you are developing, plus what you see from your competitors, some of the more disruptive newer technologies, as the market likes to call them, what do you think is really driving the spend right now? And is the focus on single vendor, or on trying out different new technologies, or approaches to security from different vendors?

Because we compete in the network plan space every four years, five years, there is a need to refresh after the equipment because the higher speed and more function, or this kind of thing. So that's where we see there's a good opportunity in the next one to two years. And it's going to upgrade to the 40 gig to 100 gig level.

Also a lot of newer attention to the APTA area, also would drive some of the upgrade of the function. And the other thing we see, the mobile device is another potential, like I mentioned in the call here. All these we're keeping driving all the demand for the network security, and also the service provider, the carrier also starting to play a more important role, especially in the mobile space.

Okay. And I'm thinking also, more specifically about the FortiSandbox that you talked about a little bit on the call. I know there are at least two other products out there from some other companies.

What is it -- and I think that is again, a slightly different approach to how to protect a network. Based on slightly different technologies. Do you think that's changing the face of how CIOs look at the threat perimeter or otherwise, versus -- I should say new ways of looking at it, as opposed to the traditional perimeter view?

I think we can offer some additional protection, but that's also not a total solution. You still need the firewall, and you still need some other VPN intrusion, all this technology has to work together. I think it's the sandbox just one of the function can enhanced some area but also not a whole solution.

I don't feel that's what -- it's still a relatively new market and so far most deployment is behind regular firewall, covers some of the protection. And also the sandbox behavior detection is also not new. It's been there for like 20 years.

And that combined, is the traditional firewall, some kind of signature-based because you totally, based on the behavior simulation it's very difficult sometimes to distinguish some good program from bad program. And also some attack can like get away easily from all these simulation things you do. So that's what has to be combined, unified solution to join together to defend.

And so far, I've not seen any sandbox to replace the traditional firewalls and other solutions yet. We just add additional protection in some area.

Okay. Great. That's it for me. Thanks.

Nandan Amladi, Deutsche Bank.

It's Imtiaz on behalf of Nandan. This quarter was good. You beat the guide for your revenue in billings.

But then if I look at the guide for next quarter, the sequential down tick for both revenue and billings is even lower than what you had in Q1 2013, which was a really bad quarter. So is that just you being very cautious or is that a reflection of the pipeline that we have in place today?

So first of all, I think you have to look at it over several quarters. I believe the ramp in Q3 to Q4 last year was different than the ramp in Q3 to Q4, and the ramp of Q3 and Q4 in 2012 was different relative to -- different than 2013, so that's a factor. You really have to look at it over a longer-term basis.

The second piece of it, I would say we're really targeting, from a high-level, from the perspective of targeting 2X or better growth from the market, which we believe currently 6% to 7.5%. And you also have to take into account we're investing in a lot of new people and also new markets and verticals, and with new products.

And so all of that may take some time, or more than just near-term. So the guidance does take some of that into account.

Yes. (multiple speakers)

What I was going to say is echoing what Drew said, three factors. One, seasonality. It's always down.

Q1, and sequentially Q1 from Q4. You're looking at a very strong Q4 2013, yes, we have a strong Q4 2012, but not as strong. And that was to Drew's point about the ramp from Q3 to Q4.

So it's that, then the seasonal factors that we talked about, things like payroll taxes and things like that, that tie back to employees. We did do hiring last year. Those are magnified a bit in Q1 of this year over last year, because all of the seasonal elements that are related to employees and benefits and things like that hit at a greater magnitude this year than they did last year, because we have more employees.

But that shouldn't apply to the top line, right? I would agree that wouldn't apply to your bottom line, but then payroll tax would not be not impact the top line going forward.

Agreed on that, but I think the early part of the answer was true.

Yes.

And second on the margins you said that would end in somewhere around the 17% range and then you're guiding to Q1 margin of growth 12%. If you ramp up the margins for the year it kind of implies you would probably end of the year at 20% range operating margin Q4?

Nice try. So yes, we're not really giving guidance beyond Q1 at this point.

I'm just doing basic math here. Just averages. It does imply that it should go up to that level by the end of the year.

I think you have what we're going to provide on that.

Okay. And one last question if I may, did you give the percentage of billings from service provider in this quarter? Do you guys give that in the last year Q4 of 2012?

So I can't find that number. If you have it handy, please?

I will send you an e-mail in a second.

We'll follow up and get that as quickly as we can.

Okay. I think that's all I have. Thanks.

If you're still on, it was 29% last year.

Okay. Perfect. Thank you.

(Operator Instructions)

James Westman, Raymond James.

Michael Turits again. You probably did answer this earlier, but again, on the CapEx side, so it's $10 million for building extra, for building in Q1. Is that $10 million total CapEx?

How should we think about CapEx for the full year? I know you went through this. I apologize.

Michael, we're not giving full-year guidance. I think we were talking about Q1.

I think what you're asking should we expect any more building costs for the rest of the year? Is that what the question was?

First of all it's $10 million in total CapEx for Q1. Is that it?

For the building.

Just for the building? Okay. So is that the only building expenditures is Q1?

Well, let me -- Michael, we are starting an ERP project, although it will probably be a small -- we could see some in Q1. We're not expecting to see much.

You have to think of it this way. You have to ramp the project, and get people onboard and start spending and we could be in position to do some of that, but I don't see much.

But the building project, that's a one quarter project only, right?

It's been an ongoing project that I believe completes this quarter.

Yes.

Okay. And should I think of ex that $10 million should I think about that $10 million for the year, plus a normal 3% of revenue run rate for CapEx?

You mean for the rest of the year?

Yes.

Again, we're not giving guidance beyond Q1. Again I would say the only anomaly that we're aware of is the ERP project potentially, which would spillover beyond Q1 and into the year and perhaps --

Even ex the building, ERP will drive it above a normal low single-digit CapEx?

Yes. Something.

Okay. Thank you very much.

We'll have a lot more on that when we update people next quarter.

Okay. Thanks.

Thank you. That's actually does conclude our conference for today. I would now like to turn it back to the hosts, if they have any concluding remarks.

Thank you for joining the call. We'll see you probably in the next few conference, and on the next earnings call. Thank you.

Thank you again.

Okay. Thank you, everyone for joining. You may now disconnect. And have a great day.