Fortinet Inc (FTNT) 2014 Q2 法說會逐字稿

Good day, ladies and gentlemen, and welcome to your Fortinet Q2 2014 earnings financial analyst Q&A.

(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, everyone. Thanks for calling back into the call today. As you know, today's call is a straight Q&A session. So, go ahead if you haven't already put your questions in the queue.

And before we start taking questions, I just want to remind you that all forward-looking statements I made earlier on our earlier call are subject to the cautions I stated at that time.

So, I think we can go ahead. With me in the room are Ken Xie and Drew Del Matto. And we can go ahead and take your questions.

(Operator Instructions)

Melissa Gorham, Morgan Stanley.

I just have a follow-up question for Drew on expenses and investments. I understand 2014 is definitely an investment year, and we have your guidance and that makes sense. But do you have any color indication on when that ramp in investments are going to start to slow and we'll see leverage? I know that you're not guiding for beyond 2014, but any guidance would be helpful there.

Yes. Again, it'll have to be qualitative, Melissa. As you said, we're not giving guidance beyond 2014. But the way we think about it right now is, one, we really believe that our investments are paying off in terms of customer acquisition. That's what we're focused on doing is increasing our market share and converging people on our technology platform. We see it working.

And I mean, ultimately, we believe that drives scale and scope, economics. The scale basically being it costs more to acquire a customer than to expand within an account -- upsell, cross-sell, renew, et cetera. And as long as we see -- right now we see pretty big opportunities to go do that. We see some of our competitors stumbling, quite frankly, which provides fertility in the overall market. I think the other point here is we have a nice tailwind from new products. Security priorities remain high. And, so, right now we're going to continue to invest.

Longer-term, I would say that if you look at it, in a way we actually are being very disciplined. I think if you look at our expense to revenue ratios, you could see that the investments really are in sales and marketing. It's genuinely there. It's not like we're building up R&D or G&A. We're not over building other things.

We're watching the revenue come, and then building those things after the fact, building, really, the revenue we've seen. We're making our bet on sales and marketing. In the Company I think that just is s -- I'd point that out because I think it's a very disciplined approach. It highlights a very disciplined approach that carries over from the past culture of the Company.

Ken is a very focused, disciplined guy with a very strong product strategy. We really just haven't historically had the sales capacity and marketing awareness to do as well as we believe we should have. And, so, now we're going after and recovering and expanding that share, if you will.

Longer-term, as we are successful, you get scale and scope benefits. The scope benefits are you get the breadth of your product portfolio, current and future, to expand into those accounts. And it costs less to acquire, as I said, than to expand. So that's a key lever.

I think the other thing is, as you sell more, you get more purchasing power, both on the cost of goods sold line, on the scale of your support organization, also just in your ability to purchase other things within the Company. And you get more out of your executive management team -- your fixed overhead, if you will.

And, so, we see a lot of opportunities. We are focusing on that but we're very focused on the economics of scale over time. And we know right now the most important thing we can do is go and acquire customers, and that's the focus. But we do know the levers, we do understand the economics, and we have the ability and the discipline to pull that off when we need to.

This is Ken. I want to add a few things. I think if you look, we IPO almost five years. So, in the first few years, we demonstrated we can be profit.

And then also, in the last few quarters we also demonstrated we can also growing. So, I think compared with some competitor, we're still more balanced among the growth and the profitability compared with some other competitors, where there's not much growing and all kind of not much profit.

I think we, like Drew said, we have the capability to really manage the future, and also we can depend on the market need depend on the position we want to be. We can be more in a control position.

That's helpful. Thank you.

And, Melissa, I would just add, we've been watching our marketing and lead-gen activities very closely, and our sales productivity. And, quite honestly, we feel like it's been very disciplined and we're actually starting to get a sense of cause and effect on those fronts. And when you get that pulse, when you really do find that pulse -- I think we have more to do, to be fair. I think you really understand how to drive the productivity levers later. You really are building a mechanism that you can adjust as needed.

Okay. That makes sense. And, then, just one quick one for you, Drew, just to follow-up on the commentary you said around cash flow growth. I think you said you can think about it generally growing in line with operating income growth. But is it reasonable to assume that it perhaps could outpace operating income growth because your billings is outpacing revenue?

Yes. And I think you could, again, plus or minus the DSO adjustment, is a good way to think about that, which is carrying through, I think, already.

Okay. Just wanted to clarify.

That's what I pointed out to signal that. If you look at the DSO, which is a function of revenue in the calculation, you could see a lower DSO balance.

Right. Okay. Sounds good. Thank you very much.

Jayson Noland, Baird.

First, just a follow-up to the previous discussion, Drew, my sense is incremental investment is more metric-based lead-gen than a brand campaign. Any color you can add to that?

Absolutely the case. I would say almost half of it is lead-gen, quite frankly -- of the incremental investment, let's say. And we monitor that very closely, as I said.

One of the benefits -- I've got to say, Ken's leadership, one of the benefits is he's very focused on ROI. I've never seen a CEO so focused on ensuring that we place bets and monitor the return and understand what we're going to do with it and what we're going to get out of it, which makes my job much easier, quite frankly, and I think is a great discipline to have as you build out marketing.

We have been also spending on events. If you attend an event you'll actually see something called the Fortinet Truck. We have a big -- I don't know if they still make Mack trucks, but I think it was a Mack truck, a big red truck that we're showing up to events with.

And we're getting a lot of positive feedback because a lot of people will have cubes and we pull up with a big red -- it's a Volvo I'm being told -- a big red Volvo diesel truck that expands and we can bring people into basically as our moving showroom. EBC -- Effective Brief Center. But we are spending more on events, as well. So, lead-gen and then events.

Okay, great. And just a follow-up -- for Ken, I think -- on the consortium announcement with Palo Alto. And that's the design, I believe, is to share malware, but not customer information across members of the consortium. Maybe some more color on that. And how many members do you think this will ultimately attract?

There's a few other big leading security vendor also interested. Because you can see Fortinet and Palo Alto, we keep growing faster, we attract a lot of customer. So, working together definitely can benefit the customer, benefit the industry.

There's a few other ones we feel probably will be adding pretty quickly because they see the benefit of sharing all this strategy information, and how to protect the customer better. So, we do expect we will add a few more quickly.

Is it possible that members of the consortium would have a benefit or at least a perceived benefit with customers as opposed to people that aren't a part of the consortium?

They need to be contribute. They need to have a certain capability to detach, and also on the intelligence side. That's why all the member need to be contribute to be part of consortium there.

I think that as a member definitely there's a more benefit. And it's kind of make like -- I think make all the certain information more available for the member company, which helps them to do a better protection and also quickly react to some other news right there. But definitely there's a more benefit for the member.

Okay, great. Thanks, guys.

James Wesman, Raymond James.

Drew, just wanted to jump back onto the cash flow for a second, piggybacking on Melissa's question. First, can you just walk me through, on the Palo Alto settlement you guys announced last quarter for $20 million, can you just walk me through what that does for cash flow for 2014?

It would have been in the Q1 number. We collected it in Q1.

Right. I think you had mentioned it was going to be amortizing over a certain period of time.

Oh, you mean from an accounting -- but the cash flows -- so, accounting and cash flow are two different things. We're going to amortize it over six years -- $20 million over six years. And the cash, we actually received the cash in March, I believe, or February. Certainly in the March quarter.

So, that would have been reflected, I think -- what do we have, like, what was the cash flow in Q1? Yes, I think it was roughly $50 million, so it would have been in there. So, if you took that -- the way to think about it, the cash flow without it would have been roughly $30 million.

Got it. So, if I'm thinking about how to model with it in there, then I would model cash flow however I would do it on a normalized basis, but then I would boost it by $20 million for this Palo Alto agreement, so to speak, as a one-timer.

Yes, but I would think it would already be in there retrospectively.

Right. It would be in there. All right. And just one last question on the operating margin guidance. I know in the past you had guided to, I think it was 17% plus or minus 1 point. I noticed you did move it down to 16% to 17%. I know it's not a big adjustment but I was just curious, why narrow the range? Any particular investment?

Look, we don't feel, to be fair, our strategy, when we were saying it all along, is, as we invest, we don't want to feel margin constrained. Ken has been very clear that being margin constrained is probably -- in the past when the Company IPO'd and beyond -- had constrained the growth of the Company. And, so, all along we've said that we won't be margin constrained. And the idea of the 17% plus or minus was to give people, I think, basically a sense, and more or less a floor, with 16% being more of a floor.

One of the reasons we gave the range is because it's hard to control hiring, how that pays back on the top line, as well. And, so, it is a bit of, it's not something you can manage once you're in the door as much. You rely on improved effectiveness to overperform. And luckily we've had that so far, or good through our efforts we've had so far. But that's the thinking behind it, if you will.

Also, when we see the opportunity coming from the market, whether it's a new service provider carrier 4G LTE or the mobile cloud or some other infrastructure buildout and the new high-speed interface, we don't want, like Drew said, we don't want to be margin constrained. So we want to keep invest in the future growth.

We feel we have a good position, the best product, the best technology. And if we invest in some opportunity, we can see better return going forward. So, that's where we try to not limit ourselves by certain margin with the current cash level close to $1 billion. So that's the message.

Got it. Drew and Ken, I think if I'm hearing you correctly then basically there's no change in investment priorities. It's just this is closer to where you see that margin coming in for the year. There's no change in priority.

I think that's fair.

Great. Thank you, guys.

Sterling Auty, JPMorgan.

Question for Ken. Ken, in these enterprise deals that you're getting more traction in, can you give us a sense how many of them are actually buying your solution for true multi-solution use versus just pure firewall VPN?

We do see the trend. There's multiple report pointing to the trend. The consolidated multi-function of gateway is really the future. There's a few surveys, talk to the CSO, CIO, they feel that can save the costs, easier to manage, can lower their security risks. Which enterprise side more adopt this one right now.

I think if you look at what are you call it UTM on a major firewall, basically just a integrated consolidated multi-function together. In early days, service provider, because they have to manage like 100,000 customers, each has different functions needed, so they see the platform whether UTM or next-gen firewall, it's really needed. And it might not be because there are cost limitation and the difficult to deploy commodity-wise is also limited on there, mostly the benefit of UTM on next-gen firewall.

Now, the enterprise also see the huge benefits, so we see the trend coming into the enterprise right now. And also the platform we have is really the ASIC salary, all these multi-function, and then the CPU address the latest news function.

We're the only one can deliver this platform with own ASIC chip. So that's where we see more advantage into this space. And especially you can see the new product ramp up pretty quick. So, we're hoping the middle range we announced earlier this month and also the big high-end box which address the tera service provider, huge at the center, also will catch up the trend.

Also Sterling -- it's Michelle -- of the five deals that we talked about in our original commentary, of those five of the enterprise deals, four of them were next-generation firewall. So, it's obviously the combination, the most common combination for integration of functionality and enterprise is firewall IPS and app control with VPN. So, the majority of our larger deals that we talked about have the integrated functionality.

That's where when you able multi-function, if you only have software running a CPU, you have a huge performance limitation and a big performance downgrade. So, that's where you can see all the testing from, whether it's third-party or from certification. That's a huge advantage we have with dedicated ASIC to cover each function, and then the CPU, leave the CPU to also cover the new function. We see the advantage we have of that, the gap gets bigger and bigger now.

Got you. And then separately, over $900 million in cash. You have been buying back stock. But now that it definitely feels you've got the wind at your back on this investment, why not be a lot more aggressive with share repurchase? Or when might we see a more material acquisition?

Why don't I take capital strategy question. As you said, we approved a $200 million buyback, the board approved back in, I believe, December. We bought back roughly $61 million under that, so we've got $139 million remaining. I would say, I think the average purchase price we bought back since inception is roughly below $20. I think it's $19.60, something like that. We've looked to buy -- we think it makes more sense to buy back the stock at lower prices. We'll continue that approach to be opportunistic, if you will.

As far as the M&A front goes, we're obviously out there looking at other evaluation -- evaluating other things. We have, I think, the whole platform concept, the convergence. When we can make the economics make sense for our customers in terms of lower cost of ownership, and we can find acquisitions that are accretive to our multiple, then we're going to take a good look at them. But right now there's nothing huge planned or imminent.

All right. Thank you.

Rob Owens, Pacific Crest Securities.

A couple questions from me. Could you talk about gross margin trends? I think they've been on a decline on a year-over-year basis now for six quarters. I know in the past you've talked about the function of mix and different things but where should this steady out?

I think we've guided, what? 70%, 71% going forward?

Yes.

So I'd stick with that, Rob. We're not giving longer-term guidance. We have more product revenue this quarter. It's more on the revenue side than the billings aside that drives the COGS. And so the products, revenue outgrows so you have a mix --. Pardon?

Particularly, your product gross margins have been down for six quarters in a row, if I look year over year.

Okay. Well, we're within our model, right? I think our model guided to about 60% product margins, and 70%, 71% overall gross margins. And we feel very comfortable that we're within it, with our strategy to provide lower cost of ownership to our customers. So, it seems like it's working, to me.

And if I think about your tax rate longer term, should we be more in that 35% range as we're thinking about next year, realizing it's very early to guide?

Yes, it'd be hard to give guidance beyond -- we're not giving guidance beyond this year.

Okay. That's all I had. Thanks.

Erik Suppiger, JMP.

Just on the headcount growth, it looks like you grew about 341 people from the year-ago quarter. Can you give us a sense for how much of that are sales hires, and how much growth you've seen in that sales organization? Obviously we can see the growth on a high level but can you give us a sense of what specific growth you've seen year over year in the sales organization?

I believe we give it publicly, the function by function, don't we?

Did you do it for the year-ago quarter? I don't see it in the year-ago slides.

I think it's in there, Erik.

Yes. Erik, we'll have to follow-up with you on that. But the headcount growth, again, if you can look at it on an E to R basis, you can see the growth in volume sales and marketing, relative to revenue, if you will.

Okay. And earlier you had talked about investing as long as you see the returns on the sales hires. What kind of growth is a good return? How can we think of, if you're going to be aggressively investing, and it's going to keep your margins in the mid teens, what kind of growth would justify that type of level of investment?

I think we want to grow faster than competitor gaining market share. So, that's where it's difficult to say what the number -- 30%, 20%, 40% -- which is better. But I think that right now the markets still are fragmented and we still have a bigger market share. Like, some good position are more important than profit.

Yes, I think that's right. Another way we look at it is we want to make sure we're making good investments and we look at the overall return over time from a customer. We know that when we land a customer, we're going to expand and renew within that customer. And we look at the economics longer term.

We know that what we're doing today, because the idea of acquiring customers gives you the opportunity to expand -- one, get a good great return on that longer term over the long term, and also expand your margin at some point. And that goes back to my earlier call of the scale and scope benefits of getting bigger, acquiring more customers, and having the ability to upsell, cross-sell, renew.

And then also keep in mind there are other favorable economics. It costs less to renew or expand a customer than to acquire a customer. Obviously sales cycles are shorter, the comp plans are different, all those types of things. You also get scale benefits on purchasing on the cost of goods sold line. Also scale benefits on purchasing just across the Company. And the scope benefits of having a broad product portfolio enables you to expand in that customer.

I think it all goes back and ties back to the strategy of, again, having customers converge on a network security platform, and driving that concept and helping customers ultimately lower their proof security, have faster network, and lower their total cost of ownership.

Okay. And then, lastly, on the CapEx, I think this year you're doing a little over $40 million. How much of that is the building and is expense that you will not be recurring next year? And from there can we calculate what the CapEx expectation could be for next year?

Yes, I can't help you with the CapEx expectation for next year. I don't have the complete breakout of the $40 million in front of me. I can get it to you.

But if you have it from the past I can give it to you going for the next two quarters. I think we're saying CapEx of about $20 million -- $12 related to the Sunnyvale building costs, and we're going to do some other building things globally. We're expanding headcount. You obviously need more space. And we're going through some rent versus own calculations there, let's just say.

Then there's also the ERP project, which is about $5 million of that. And then another $3 million of just other general CapEx items. so, I don't recall, and I don't have it in front of me what the other $20 million was in the first half, if it is $40 million in total. But we can get that. I could follow up with you on that. I would have been primarily the building, though. We have building and a solar project in Sunnyvale.

Are those spend items going to continue into next year or are they going to be done, those investments done, by the end of this year, for the most part?

Again, we're not giving CapEx guidance going forward. But ERP projects logically take longer than six months. And as we continue to grow, we have to do our real estate planning.

Okay, thank you.

Jeff Kvaal, Northland.

I'm delighted to be part of the story and happy to catch you on in a good quarter. So, thank you. I wanted to ask a little bit about the margin structure. I think one is on the gross margin structure. Can you help us, help me a little understand the variables there and why things may be a little bit lower in the back half of the year? What's moving around there? And then, secondly, just conceptually over time, I think, is the plan to allow the operating margins to drift higher as revenues grow? Or do you want to continue to reinvest in the business?

I'm not sure. What margins are you referring to when you say getting lower?

I just wanted to know the variables in the gross margin structure and what we should be thinking about, whether things should be going up or down over the back half of the year.

Again, I think, as I was just discussing with Rob, I think the way -- obviously, the product margins are lower than the support margins. And you have some professional services which even have lower margins, but it's not a significant amount of our business. The high-end products tend to have higher margins; the low end products tend to have lower margins.

But, again, the way we run the business is, we know that we have a 60% product margin in our model. You tend to run the business that way. So, I would keep 60% as the blended number. And, again, if there's a significant mix shift one way or the other it could get better or worse on the product side. But that's the variable there.

On the longer term operating margin, again we're not giving guidance and it goes back to the last point. I think what we really are doing now is acquiring customers. So, we're looking out, growing share, acquiring customers, which gives us the ability to expand margins through scope and scale. Scope benefits being the breadth of our portfolio -- upselling, cross-selling, as well as renewing. And then scale benefits. I guess renewing would go into the scale category, as well, depending upon how you want to think about it.

But also, it costs less to acquire a customer than to renew a customer. And you get scale benefits on the purchasing lines within COGS and just general purchasing around the Company, which are key levers.

And what I might remind you of is, if you look at our expense to revenue, you can see that our spending is really focused, the thing that's really changed, is on the sales and marketing line, where it's gone up. And, so, we've been very disciplined on R&D and G&A. We're just not spending to spend or spend broadly. We're very focused on spending in sales and marketing and return on investment.

That's what we spend a lot of our time doing, is really trying to understand how we spend and where we're getting the return. And, so, when you do that, and you think of the scale and scope argument, you really do have the opportunity to twist the dials when you see the growth selling off or you see the opportunities go away. But right now, to be fair, we see opportunity out there.

Network security people are converging onto -- they're looking to do less point solutions, converge on a platform. Some of the incumbents seem to be maturing and I would say struggling, perhaps, which provides opportunity. Security market as a whole seems to be a pretty good space with all the headline events. And then we have -- obviously, we believe the strength of our product portfolio, both in terms of performance, speed. We certify the products. They're very security effective. And the total cost of ownership argument provide a great opportunity to invest right now. It's a great thesis.

Okay. Thank you very much.

Gregg Moskowitz, Cowen.

Just one quick question. You continue to build out your AWS offerings. And recently, Ken, you came out with a subscription sale for FortiWeb VM. And I'm wondering if there's a point at which you think -- and I realize it's really today -- but a point at which you think the AWS-related businesses or business will become meaningful to Fortinet?

I think the reason I mentioned in the script is really, we really make it as a flexibility, a new trend actually for some of the service providers. So, AWS is a good example and we may expand into other cloud virtulaized platforms. But that's -- some customers, they have the need, like if they launch some of the new applications, new web service, they may need some, like a utility service. So, that's where we're the first one to offer these kind of services in security space.

That just demonstrates we have the capability to really meet customer needs and also have a lot of engineered power resource behind to supporting the customer needs. But it's right now still relatively small so I don't think it's material right now.

Okay. That's helpful. Thank you.

Walter Pritchard, Citi.

It's actually Jim. I'm wondering as to, with these enterprise firewalls, where customers are deploying it, whether it's at the gateway, the edge, data center? Any color on that?

I think still it's difficult because sometimes the enterprise data center I view more a gateway. It's different than some other big data centers, some service provider or some other, like huge, like finance service or some other huge enterprise has. But definitely they are replacing the traditional single-function firewall-only appliance right now.

Yes, at the data center. Jim, it's Michelle. The 3700D especially is positioned well as a enterprise data center appliance. So, I think what Ken's saying is his idea of a data center might be a little deeper than what the general industry looks at. But from what the general industry looks at and competitors look at is data center, that's where the majority of our deployments, especially for the new products, are going. And pretty much every enterprise deal that we talked about in our commentary was a data center deployment.

Okay. Great. That's awesome. And then I know, Drew, you're not talking about the out years, and you said it, it feels like 100 times here, but should we think of 2015 as more of a year like 2014 or a year more like possibly 2013 on a qualitative basis?

I would just say what I just said. As long as we see opportunity, we're going to continue to invest.

Okay. Great quarter, guys. Thanks.

Jonathan Ho, William Blair.

Just in terms of the enterprise market, I just wanted to understand the situation a little bit better. Are you starting to see now a bit more demand pull where customers are going to the resellers and asking for Fortinet products or is this still very much in the stage where you're educating the channel on the value proposition and trying to get them to push the product more?

That's a good question, Jonathan. I don't think we have a perfect answer for you. But I'll try it like this.

We've been doing more -- I don't think brand awareness is the right word -- I think more like I said, if you look at where we're spending the marketing dollars, it's really lead-gen and events. And the events are often relationship development, if you will. And so I think we're getting some of that. But a lot of it's coming through lead-gen online or trade events. And I'm not sure, that's a gray area where you call that -- are they pulling or are we pushing because you're meeting in the middle ground, if you will.

But I think a lot of the lead-gen activities are centered around people who are doing something online. So, we see an interest. They recognize the brand probably more than they did.

If I were to think about it going forward, I still think we have opportunity we can do more there, and it would be nice to see more pull. I think there's really more opportunity there in terms of, I think the story's starting to get out there. I think there's more to go. And I think we will get more pull.

We see, where we invest it seems to pay off. Again, we're very focused on, on a weekly basis, looking at what we did and what it looks like it generated in terms of lead activity and how it developed in the funnel. I wish I had a better answer for you than that. I think it gets into a gray area anyway. I do think that we could get more people pulling us.

Got it. That's perfect as far as an answer. I know this is not black and white, in many cases.

Last question for me is, in the APAC region we did see a pretty notable pickup in terms of activity. I know you guys described some of the growth there. But it seems like in the past there was a little bit of an emphasis on big elephant hunting or some of the larger contracts. And then you guys had talked about maybe shifting that focus to more building a steady eddie distribution channel business that would be a little bit more recurring in nature. I just wanted to see, in terms of the success you've seen in that region, what maybe is driving it today.

I think APAC, actually different country have a little bit different model. Some countries large channel focused; some countries more big product focused. So we just try to, like if the country has more channel focus we try to have the team try to do more work, like a big product focus. And then the country more product focused we starting try to add some channel team. So, that's where we see the improvement coming from.

Overall, I think probably we still have some more room to keep improving in APAC. So, we feel pretty efficient and we still can keep investing in growth there.

Great. Thank you.

(Operator Instructions)

Shaul Eyal, Oppenheimer.

One final question on the heels of the headcount increase from the conference call. The sales and marketing, the new sales and marketing people you are bringing in over the past few quarters, where are you recruiting them from? Is it some of your competitors? Partners? System integrators? Or all of the above?

Certainly, some of our competitors. And I think there's probably a little bit of -- without having detail, I wouldn't want to mislead you, I don't have the detail to know if we're getting them from system integrators for sure. What tends to hit the grapevine around here, so to speak, or hit our level of attention, is more the competitive hires.

I wouldn't be able to really share. I don't think it would be right to share names, but we do see some opportunities. We do get a lot of them. I'd say that's where we get a lot of inbound requests, a lot of inbound activity, in terms of interest.

Got it. Okay. That's good. Thank you for the color. Appreciate it. Good luck.

At the moment I'm showing no further questions. I'd like to turn the program back to your host for any concluding remarks.

Thank you very much for all of your support. We really appreciate your time and paying attention to Fortinet. And we look forward to probably meeting with most of you in the near future. Thank you very much.

Goodbye, everybody.

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