Fortinet Inc (FTNT) 2018 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Fortinet Q3 '18 Earnings Announcement Conference Call.

(Operator Instructions) As a reminder, this conference is being recorded.

I would now like to introduce you to your host for today's conference, Peter Salkowski, Vice President of Investor Relations.

You may begin.

Thank you, Gigi.

Good afternoon, everyone.

This is Peter Salkowski, Vice President of Investor Relations at Fortinet.

I'm pleased to welcome, everyone to our call to discuss Fortinet's financial results for the third quarter of 2018.

Speakers on today's call are Ken Xie, Fortinet's Founder, Chairman and CEO; and Keith Jensen, our Chief Financial Officer.

This is a live call that will be available for replay via webcast on our Investor Relations website.

Ken will begin our call today by providing a high-level perspective on our business.

Keith will then review our financial and operating results and conclude by providing our guidance for the fourth quarter before opening up the call for questions.

(Operator Instructions)

Before we begin, I'd like to remind everyone that we will be making forward-looking statements on today's call and that these forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those projected.

Please refer to our SEC filings, in particular, the risk factors in our most recent Form 10-K and Form 10-Q for more information.

All forward-looking statements reflect our opinions only as of the date of this presentation and we undertake no obligation, and specifically disclaim any obligation, to update forward-looking statements.

Also, all references to financial metrics that we make on the call today are non-GAAP unless otherwise stated.

Our GAAP results and GAAP to non-GAAP reconciliations can be found in our earnings press release and in the presentation that accompanies today's remarks, both of which are posted on our Investor Relations website.

Lastly, all references to growth are on a year-over-year basis unless noted otherwise.

I will now turn the call over to Ken.

Thanks, Peter, and thank you to everyone for joining today's call to discuss our third quarter 2018 results.

I'm pleased with the strong third quarter results as billing increased 22% to $528 million.

Total revenue was up 21% or $454 million with product revenue up a solid 20%.

Non-GAAP operation margin was 24%.

We post non-GAAP earnings per share of $0.49 and were again profitable on GAAP basis with earnings per share of $0.33.

We aim to continue to deliver above market growth balance with profitability.

We are experiencing strong global demand for our Security Fabric platform due to enterprise digital transformation, increasing consolidation and the network security refresh cycle.

Today, enterprise needs security that will go well beyond Accelerate security product.

This trend are expanding and opening up new opportunities for broad, integrated and automated security fabric protection.

The Security fabric platform offers 3 major competitive advantages.

First, our Fabric platform offers a broader set of end-to-end solution, providing protection from IoT for data center both on-premise and cloud.

Organically (inaudible) from 2 decades of innovation, the Security Fabric provides the best automation and integration in the industry.

An example is our Security Fabric cloud offering on Azure.

We now provide the most extensive offering of integrated security solution available on Azure including FortiGate Next-Generation Firewall, FortiSandbox, FortiTest, FortiWeb, FortiMail, FortiManager and FortiAnalyzers.

A second differentiator is our superior price and performance capabilities.

Fortinet is the only security company that built ASIC security process of SPU with integrated security and a narrow functionality, which provide 10x speed and performance over other software approach.

As a result, Fortinet's product provides significant and better security performance of both cloud and edge computing.

The third competitive differentiator is our Security Fabric platform is the extensive third-party recognition and validation we have received from NSS Labs and Gartner.

Fortinet has received a recommended rating in 9 out of 9 NSS Labs category, more than double the number of recommendations received by our nearest competitors.

Fortinet was among the only 3 vendors out of 10 that received a recommendation for their SD-WAN solution and that the only vendor to have received recommended rating in both SD-WAN and the Next-Generation Firewall group test.

Fortinet Fabric platform solution have now appeared in 7 Gartner Magic Quadrant over the past 12 months.

Our SD-WAN solution was recognized as one of the top 5 solution in Gartner's 1H Magic Quadrant.

Also, Fortinet was named in most of Leaders quadrant for next-generation enterprise firewall and unified threat management.

SD-WAN plays a pivotal role in realizing the true benefit of digital transformation and is forecast to reach $4.5 billion by 2022 come up from $1 billion in 2018.

Gartner stated that by 2023, 50% of the new firewall purchases in the distributor network will utilize SD-WAN features.

Fortinet offers the only solution that provides both SD-WAN and the Next-Generation Firewall functionality in a single integrated offering for enterprise and SMB.

We believe this technology advantage puts Fortinet in a solid position to catalyze on strong IT-wide market growth.

Last week, Fortinet announced the acquisition of ZoneFox, a cloud-based inside threat detection and response company.

The acquisition further enhanced the Security Fabric platform and strengthened our existing endpoint and SIEM security through machine learning, providing a better and faster response to inside threat.

Innovation is core to Fortinet's mission.

In the third quarter, we surpassed the milestone of 500 issued patents, 3x the patents issued to our nearest competitors.

We are pleased to be added to the S&P 500 index, an acknowledgment of a double-digit year-over-year growth every quarter since going public in November 2009 and our consistent GAAP profitability.

We're excited about significant opportunity ahead, and we will continue to invest while achieving a goal of 25% operating margin at 2022.

I want to thank the Fortinet team and our partners for their ongoing hard work and our customers for their support.

Now I will turn the call over to Keith for a closer look at our third quarter performance and our fourth quarter guidance.

Thank you, Ken.

Before I start, I'd like to note except for revenue, all financial figures are non-GAAP and growth rates are based on comparisons to the prior year period unless stated otherwise.

Any slide references that I make during my prepared remarks refer to the presentation that is posted on our Investor Relations website.

I'm very pleased with our third quarter results as the Fortinet Fabric continue to resonate with existing and new customers.

In the third quarter, we posted revenue growth that outpace the industry and operating margin that was better than expected and strong free cash flow.

We believe we are well positioned to outperform the security market in the fourth quarter.

We're delivering an integrated and high-performing Fabric product portfolio that is driving an industry leadership position.

This claim is supported by the independent recommendations we received from NSS Labs and Gartner.

Specifically, I would point to our 9 for 9 record of NSS Labs product recommendations as well as Gartner evaluating Fortinet as a leader in both our UPM and enterprise firewall Magic Quadrants.

We remain committed to balancing above market revenue growth with increasing profitability as we work to achieve our non-GAAP operating margin goal of 25% for the full year 2022.

Now for our third quarter results starting with revenue.

As shown on Slide 3, revenue grew 21% to $454 million.

Product revenue growth accelerated to 20%, resulting in revenue of $165 million.

Product revenue included the net benefit of $2 million related to the required accounting change from revenue.

Excluding this benefit, product revenue growth accelerated to 18%.

Service revenue grew 22% to $289 million.

FortiCare, our traditional support offering, grew 26% to $121 million.

FortiGuard, our security subscription offering grew 20% to $157 million.

Deferred revenue increased 27% to $1.5 billion.

Average contract length increased 1 month to 26 months and was flat sequentially.

Turning now to billings.

Billings grew 22% to $528 million.

Each region experienced strong billings growth in the Americas, APAC and EMEA, up 25%, 22% and 19%, respectively.

The U.S. provided strong enterprise growth in the quarter accounting for 7 of our top 10 and the majority of our top 25 customer billings.

Billings to our global 2000 customers excluding service providers and MSSP's on a trailing 12-month basis, grew 31%.

One of our top 25 billings in the quarter was a 7-figure transaction with the same large U.S. retailer we highlighted in the first quarter.

They are then 7-figure all cloud transaction.

The new transaction is focused on our ASIC based FortiGate's, including several of our high end 6000 series of products.

These high end FortiGate products will be deployed this year to secure connectivity with their earlier cloud deployment.

We also completed a quadruple competitor displacement with a large U.S. based financial services firm initially looking to improve their internal segmentation capabilities at a very successful proof of performance concept, the firm decided to displace additional vendors, consolidating their functionality with Fortinet and lowering their total cost of ownership.

Also in the quarter, a large U.S. multinational financial services firm that was highlighted in our last call appeared again as the top 10 customer with another 7-figure billing this quarter.

Illustrating the strength of our mid-enterprise and enterprise business, the number of deals over $250,000 grew 27% while the billings associated with these deals increased 34%.

The number of bills over $1 million were fairly consistent year-over-year, moving from 32 to 30.

The total dollar billings associated with this $1 million plus deals increased 32%.

Service providers and MSSPs continued as our largest vertical accounting for 19% of billings, up 2 points year-over-year.

Network security billings increased 22%, accounting for slightly more than 3 quarters of total billings.

Billings for non-FortiGate grew faster than the FortiGate business.

The Security Fabric, which is the largest component of our non-FortiGate offerings, benefited from customers recognition of its value, performance and integrated security coverage.

Cloud billings, our top 5 public cloud providers, continued to experience growth in excess of 100%.

Moving back to the income statement, our third quarter gross margin increased 50 basis points to 76.5%.

Product gross margin was down 120 basis points to 57.4%.

On a quarter-over-quarter basis, product gross margins were up 90 basis points as we continue to transition through a certain level of volatility related to new product introductions.

Service margins expanded 120 basis points to 87.3% and 50 basis points sequentially.

Including the commission benefit associated with the required change in accounting, total operating expenses grew 11%.

Excluding the benefit from the required commission accounting change, total operating expenses would have been up 15%, including a 240 basis point benefit from the commission and revenue accounting changes, our operating margin of 23.9% was up 520 basis points year-over-year.

Excluding any benefit from these accounting changes, our third quarter operating margin increased by 280 basis points year-over-year.

The operating margin improvement was mostly driven by leverage in our financial model as revenue growth outpaced total operating expenses.

Slide 14 shows a line-by-line comparison between our non-GAAP results and the non-GAAP results excluding the adoption of the new accounting rules.

In the fourth quarter, we expect total operating margin benefit from the required accounting changes to be about 250 basis points.

In the full year, the operating margin benefit is expected to be about 300 basis points.

Total headcount at the end of the third quarter was 5,639, up 15%.

Net income for the third quarter was $87 million or $0.49 per share based on 175.7 diluted shares and was up 75% year-over-year.

Non-GAAP effective tax rate was 24%.

Moving to cash flow and capital summarized on Slide 7. Cash from operations was $177 million, up 9% year-over-year.

Free cash flow was $159 million, up 13% year-over-year.

On a year-to-date basis, free cash flow increased 32% to $417 million.

Capital expenditures in the third quarter were $18 million.

Given the strong growth we've experienced, we will outgrow our existing office base in Sunnyvale.

As a result, we have started construction on a building adjacent to our existing office.

In the fourth quarter, we expect capital expenditures in the range of $5 million to $10 million related to this building.

We expect total fourth quarter capital expenditures to be between $20 million and $30 million.

Total capital expenditures for 2018 are expected to be between $60 million and $70 million.

Capital expenditures related to the adjacent building are expected to be in the range of $60 million to $80 million in 2019.

We plan to provide quarterly spending updates throughout 2019 and plan to move into the building in 2020.

As I turn to guidance provided on Slide 9, I'd like to remind everyone that the forward-looking disclaimer Peter presented at the start of the call applies to the guidance I'm about to provide.

For the fourth quarter, including the benefit of ASC 606 and an immaterial impact from tariffs on cost of goods sold, we expect billings in the range of $620 million to $635 million; revenue in the range of $490 million to $500 million; non-GAAP gross margin of 75% to 76%; non-GAAP operating margin of 24.0% to 24.5%; non-GAAP earnings per share of $0.50 to $0.52 which assumes a share count of between 178 million and 179 million.

In 2018, including the benefit of ASC 606 and an immaterial impact from tariffs from cost of goods sold, we expect billings in the range of $2,125,000,000 to $2,140,000,000; revenue in the range of $1,785,000,000 to $1,795,000,000; non-GAAP gross margin of 75% to 76%; non-GAAP operating margin of 21.5% to 22%; and non-GAAP earnings per share of $1.72 to $1.76, which assumes a share count between 174 million and 176 million.

Before I turn the call back over to Peter, I'd like to thank our partners, our customers and the Fortinet team for all their support and hard work.

I'd also like to welcome the employees of ZoneFox to the Fortinet family.

I'll now hand the call back to Peter.

Thank you, Keith.

Operator, we're ready to open up the call for Q&A, please.

(Operator Instructions) And our first question is from Jonathan Ho from William Blair.

I just wanted to start out with maybe the Security Fabric.

It sounds like this is another strong quarter in terms of demand.

Can you maybe give us a little bit more detail in terms of what elements of the Fabric maybe stood out?

And also do you have a separate quota for the sales force to retire related to the Security Fabric?

Jonathan, it's Keith.

Second question first.

No, we do not have a separate quota for the Fabric for the sales team.

If you look to the product family, I would highlight the access points and the switches performed very well in the quarter and they continue the patent that we start to see shaping up in the beginning of the quarter as well.

I think also, I would add to that list FortiManager, FortiAnalyzer, FortiSIEM.

Overall, the product suite of the Fabric performed very well during the quarter.

Excellent.

And then just looking at the operating margin trends, I mean, you guys have guided to a pretty strong operating margin in the fourth quarter after delivering a strong third quarter.

How should we be thinking about that on a go-forward basis?

I know you guys make some investments earlier in the year as well, that's to show leverage, but I just want to make sure that we're thinking about that the right way.

Yes, we're not in a position as we go through the budgeting cycle that we're in right now for the coming year.

Its really talk about guidance for 2019.

Obviously, we're very pleased with the performance of the company in Q3 on the top line and on the operating margin line.

I think the productivity from the sales organization, we're seeing that come into play in the third quarter.

We're very pleased with that.

I'll probably leave it to Ken to talk a little bit about market forces and what we're seeing beyond just the Fabric growth and other comments as well.

Yes.

Actually, with our strong building growth like 22%, our headcount hiring is probably little bit behind that.

So the healthy way for long-term growth need to be seen together for the top line growth and the headcount growth.

So that's where we may catch up little bit.

On the other side, we do see the refresh cycle still going on.

Maybe it will last another 1 to 2 years.

The other opportunity we see is SD-WAN is a huge opportunity.

Like I mentioned in the script, in the next few years, we'll reach from this year, $1 billion to $5 billion.

And we're the only vendor that can provide both SD-WAN and also security and yes, single pass, single solution.

That's a huge advantage for lot of enterprise, SMB, service provider.

We see a very strong demand.

We believe this trend will be carried for another few years of growth -- very strong growth.

So that's why we want to keep in balance among the growth and the profitability.

So we were company who cares both the top line and bottom line.

We also have the commitment 25% operating margin by 2022, but we also want to keep investing in the growth going forward.

Our next question is from Sterling Auty from JPMorgan.

I get a number of questions from investors trying to understand, especially in the high end enterprise, how much of the demand and success you're seeing is still data center focused versus now with all the talk of Fabric and micro-segmentation?

So just maybe some additional color around what's driving the success, in particular, in the high end enterprise partner business.

We do see both growing well, whether in the data center, cloud and also in the internal segmentation and edge computing.

Because once the enterprise started realize really when they moved the data to the cloud, they also need to secure the access to it and actually at some additional risk because now in the cloud, if you cannot secure and access that then the data has probably more risk, more danger there.

So that's how to secure and access the data especially leverage, like SSL encryption and others things are very, very important.

The most other current network security solution there have a big performance issue with SSL encryption.

But we have the ASIC solution, which when you do the SSL encryption for the traffic, almost no traffic drop compared with the other solution test, it's about 80% drop off this report.

So that's where we see sort of enterprise as a hybrid and I will move some data to the cloud compared -- and some more internally.

So they need to balance them, once the data goes to the cloud, once the data -- once the computing is still within the edge, within the enterprise.

So we see enterprise definitely keeping increase the security spending even some time IT spending probably pretty much flat.

So (inaudible) we're healthy, and we continue to believe the security will grow like 10% or even above in the next 10 plus years.

The total market is kind of reach like $1 trillion in the next 10 to 20 years.

It is a very healthy, long-term growth market.

Our next question is from Shaul Eyal from Oppenheimer and Company.

Ken, one for you, one for Keith.

Going back to the refresh product cycle, you've been around your entire career within the security arena.

As you think about the current cycle, would you characterize it as if we're in the initial innings, midway?

How would you think about it versus prior cycles, timing and maybe even demand and product-wise?

I feel this cycle compared to the rush buy happening end of 2012, 2013, this probably last a little bit longer, maybe a few quarters longer, maybe lasts for like 2 years, 2.5, 3 years.

We are probably close to the mid-of it.

But it's -- the difference is that this time, they consider multiple solution together whether it's Fabric or platform, so they also need to find a way to integrate, to automate a solution compared to the life cycle that gets refresh from the regular firewall to the next generation firewall UTM.

And that's where this time they need to consider how this different piece can work in together whether from the network side end point, the cloud, the network inside even the -- some storage and IoT.

So that's where they kind of have a more bigger picture or kind of infrastructure kind of approach compared to that's the network side.

So that -- but also we see some time the new infrastructure, whether the SD-WAN or the 5G, similar like in the past, we see also very strong kind of fabric growth, really the wifi also need to be considered together with security.

So that we see as a kind of a -- the total infrastructure Fabric platform (inaudible) is happening right now.

And consider the security more integrate or designed with the infrastructure instead of just like add on top of some infrastructure.

Understood, thank you so much for the color.

Maybe one for Keith.

Really strong showing on the DSO front, probably lowest in some quarters.

Doesn't matter whether it's 605 or even 606.

Can you talk to us about that and maybe also about linearity trends you have been experiencing through the quarter?

Yes, thanks for your nice comments.

Yes, I think DSO came in.

I don't think there's anything really unnatural in the numbers and that kind of leads up to your second part of your point.

I think linearity in the quarter was indeed good and it kind of held its case, commented on about the first month of the quarter and the last earnings call being good and I think it kind of continued on through the quarter.

And I think you're seeing that in the DSO number.

Our next question is from Andrew Nowinski from Piper Jeffrey.

I just want to ask about the large customer win that you had, the quadruple replacements.

Since I was clearly more than a firewall replacement, can you give us any color as to what products that customer consolidated on to the Fortinet platform?

Yes, you're going to -- when you start to multiple products like that is going to go beyond the firewall right into the Fabric, right?

And more often than not, you'll see as I indicated previously from a hardware viewpoint, the access points and the switches are doing very well.

And then you roll into that typically, a suite of FortiManager, FortiAnalyzer, SIEM, cloud et cetera.

Okay, got it.

And then just maybe a comment on the large deals.

They look like they were down, I am talking about the $1 million deals were down sequentially.

Did any deals push out into Q4 that might have caused that number to be down year-over-year?

Yes, I don't -- I think when you look at the population, again I think it was off by 2, I think year-over-year from 32 to 30.

You're going to get a little bit of volatility in that segment of the market, so I'm not surprised by it.

I was very pleased to see the total dollar value that was build in those large deals.

The number was smaller.

The total billings were up about [32%] (corrected by company after the call), I believe I said.

Our next question is from Keith Bachman from Bank of Montreal.

I wanted to ask 2 questions, if I could.

First, the services revenue has been humming along at 25%, 26% year-over-year growth for 5 quarters.

This quarter, it decel-ed a little bit again larger number, but decel-ed to 22%.

While the product revenue, it is second straight quarter of really good growth.

And so I'm just wondering was there anything on the services side?

Any reason why it decel-ed outside of larger numbers?

And what does that portend that the product revenue growth has been so strong for a couple of quarters now?

Does that -- is it suggesting inflecting point in terms of acceleration back to the services side?

And then I have a follow-up, if I could.

Keith, it's Keith.

The -- look, I think, obviously we're very pleased with the results of the quarter both from the top line and the bottom line.

And as you know, we manage or we guide to total revenue into the margins.

So within that mix of services and products, we're very pleased with where we end up, including the gross margin line.

To get a little bit more specific to your question, one thing we looked at was our renewal rates were very good in the quarter up over what we normally see.

The attach rates were very good.

The mix of 24/7 versus 8/5 support was very good, it picked up again.

As I said, renewal rates, attach rates, so the -- I think as a larger base is part of it as you point out.

I think the other key element of this is something that we talked about a little bit in the Analyst Day, it is the Fabric platform came online.

We expected if you bring with it a higher mix of hardware and that higher mix of hardware, which you're seeing in the top line and the product revenue growth and a smaller mix on the services.

And I would really point to access points and switches for that.

So I think we're really starting to see the impact of the platform strategy from the Fabric and how it's appearing and the success it's driving in the income statement.

Also, we introduced a new service called the FortiCare 360.

That's beyond the traditional FortiCare 8x5 supporting the 24/7 supporting.

This will be helping the Fabric service going forward.

It's helping to manage to configure, to deploy and also to help check out some of the Fabric solution there.

It's still in the early ramp-up stage, and -- but we do believe including the future Fabric and also the new trend SD-WAN, so this service needed, and we see also very quickly ramp up even that's in a very early stage, we do believe this will help in the future service growth.

Okay.

And then my clarification, Keith is just you guys have provided operating margins for the year.

And let's just say for giggles, it ends up being 22% operating margin similar to ASC 606.

When you talk about growing to that target of 25%, I assume the base that we should think about in 2019 is 22%.

In other words, the base isn't ex the benefit of the accounting translation as we think about '19.

Yes, I think the way we always described it is that, that's a 605 number, and we're tracking the 605.

And part of that -- the reason we're looking at the 605 number in terms of that commitment is as you can see it's moving around on us, right?

It's coming down from the first quarter to the fourth quarter, and it can be impacted by things like product revenue mix, top plans, service term, et cetera.

So I think just to give us all very honest and outside the table it's a 605 goal.

Okay but as we think -- so if we think about 2019.

Again, just using 22% as the reference point, should we expect operating margins to be flat, down or up relative to 22%?

For 2019?

Yes.

Yes, I'm going to pause on providing guidance for 2019 other than offering up our long-term model that we talked about before and what we're targeting over time.

Just let me go through my budgeting process and cycle before I do that.

Our next question is from Gabriela Borges from Goldman Sachs.

I wanted to follow up on some of the momentum you're seeing in the Global 2000.

I don't know if this is for Ken or for Keith.

Could you comment on to what extent the volume of opportunities, the number of engagements that you're invited to bid upon, how is that changing relative to history?

And then if you could also comment on win rates for Global 2000 business.

Once you are invited, how often do you win and is that number changing at all?

I would say, the pipeline in total, we were very pleased with the direction of the pipeline.

And the segmentation of the pipeline, I think the fact that I'm pleased with [price of book] are a very important SMB part of our business and also the Global 2000 part of the business.

Yes, I think the -- we're well-positioned with an opportunity to continue to lead the SMB and expand into the enterprise.

And I think that trailing 12-month number of 31% growth is a very positive indicator.

In terms of wins and losses, that's -- we're not -- other than the carrier MSSP, we're not the incumbent.

It's always a little more challenging to displace the incumbent.

But I think when we have those opportunities, we're doing well and we're very pleased with it.

Yes, also we started to invest in the marketing supporting -- to support in the, to support the sales into the Global 2000.

We see pretty good progress there.

And at the same time, even within the sales, we're starting kind of a separate sum of the effort of the organization, by focusing the channel, focusing on the Global 2000.

So that's where -- once we have the focus, we can see the growth pretty healthy.

That's helpful.

And a follow-up on the gross margin.

I can appreciate that the gross margins are expanding in aggregate year-over-year, but I want to talk specifically on product gross margin.

Could you help us understand, that's for Keith, when that number might start to trend upwards.

Or when you might start to see stabilization within that product gross margin rate?

Yes, I think that's a fair question.

I would probably just offer you some context.

It's going to be impacted by the mix obviously, between products and services in a given quarter.

Specifically, when you look to Q3 to Q4, the sequentiality, our mix typically picks up a little bit to product, which puts a little bit of pressure on the gross margin line.

I do expect that we're going to continue to see growth and improvement in total gross margin and largely driven by the services component of that.

And I think we're -- kind of fast-forward to the punchline, we're on track to that 25% goal and that gross margin line is a component of that.

Yes, I also like early this year, during the Analyst Day, a preview there.

And also we do see, the amount in gross margin target is 80%.

And at the same time, we refresh some of the middle range product.

During the refresh time, the gross margin just drop a little bit and then will become back up once the ramp-up start and the refresh, starting to finish.

So we do see the long-term trends still the same.

And we're still keeping the 80% target for gross margin after.

Our next question is from Fatima Boolani from UBS.

Keith, maybe to start with you.

Just on the service provider business.

Just according to my math, that was a nice acceleration off of the second quarter.

So maybe -- can you give us a sense of what sort of budgeting behavior is actually playing out in the service provider vertical that underpins the strength?

And as we look into next year, what sort of activity are you anticipating?

And another follow-up, if I may.

I think the -- and Ken may want to weigh in here a little bit.

But I think the MSSP's portion of that service provider is really what you're seeing and that's historically been the largest part of our business.

And we're seeing that do exceeding well.

I think the SD-WAN discussion now is really coming into play as part of that business as well.

And I think you're seeing that starting to drive -- I know we have had some conversations with customers.

That SD-WAN opportunity is really starting to drive some pipeline growth.

I think 5G will be a part of it as well.

Yes, that is where, we do see the SD-WAN technology starting to kind of be used by some new relatively small service provider to try to get market share from the traditional MPLS offered by some of the bigger carrier service provider.

So -- at the same time, the 5Gs, some other technology started taking off now.

So often our speciality is working with service -- all kind of service provider, both large and small, and offer the best product and tool and the same security into the infrastructure -- into the service they're offering.

And so we see this strategy working quite well.

That's where we're the only one kind of offered SD-WAN together with security, the Wi-Fi together with the security and also going forward, some other new things all with security together.

So that's the strategy, the service provider like a lot.

That's where compared with some other, like a network vendor or the security vendor, they have to catch up to buying company to follow the trend, compare the kind of a long-term invest in all these area a few years ago and keeping investing for the long term.

And offer integrated ultimate solution, which is much better for the service provider, for the customer.

That's helpful.

And Keith, just a quick one.

Last couple of quarters, you gave us some color on shipment volume.

Just wanted to see if there is an update there.

And to the extent it sort of held into the 20 percentage-ish ZIP Code.

How should we think about that from a sustainable basis, looking out the next couple of years as we think about hybrid architectures and cloud migration.

Yes, sorry about that.

I know we were just consolidating on words on my script.

FortiGate unit shipments up 16% year-over-year.

All shipments up 20% year-over-year.

I mean, full 21, but I'll go with 20.

Our next question is from Daniel Ives from Wedbush Securities.

This is Strecker Backe for Dan Ives.

And our question is, based on your conversations with customers, are you seeing an inflection point with larger scale security deployment in the field?

I see more multiple solution integrated together to deploy.

Yes, we do see some as the deals get larger, because while you have a multiple solution, integrate ultimately together, thus you can -- I'm not sure that's a trend or not.

It's still too early to say like a bigger deal or the bigger customer like over $1 million, the size get bigger, the number not quite or flat.

But I do see that deployment starting to be more integrate, more kind of multiple solution working together now.

Yes, I would just kind of -- Ken's spot on, I would just kind of remind people that often times we see staged deployments with our large enterprises.

And so you will see some of these deals appearing -- for a single customer, they may buy in Q2, Q3 and then again in Q1 or something like that.

So it's difficult to look at individual customer because of a -- it's more than 1 quarter.

And offer a comment on that.

But yes, the enterprise does drive larger deal sizes, whether that's just because of the number of firewalls or it's because of the Fabric products that are being attached to it.

Yes.

Also, we believe we have a huge advantage because most of our Fabric products are internally organic designed from day 1 work to work together, integrate together.

And also including some networking function like SD-WAN compared to some other company that do purchase some of these product solutions, which is obviously more difficult for the integration and our phasing -- you need time to make it work together.

So we have a huge advantage.

So we do see the benefit getting bigger and bigger now.

Our next question is from Rob Owens from KeyBanc Capital Markets.

As you guys are clearly in share gain mode, especially given the product success that you're seeing, what's the competitive response been?

What is the pricing environment like?

We don't have any price pressure right now.

So that's why we're keeping, feel that the gross margin can keep improving because one of the key differentiator is we're the only ones that is on ASIC chip and now, we reached close to 4 million FortiGates deployed.

And also, the economies of scale have been working, whether the 2 sided effect.

The more we deploy, they can also lower the average cost for the chip and also design cost average per chip.

And at the same time customers see more benefit, we can invest more in there.

But ASIC chip, it takes a long time, 5 to 10 year, to see the benefit.

So far, none of our competitors have been able to invest early enough to get in the space to see the benefit we have.

So once we have a bigger and bigger number unit deployment market share, we also see accelerate benefit will help us to keep the efficient advantage more.

I think that's pretty much...

I guess, second with regard to the beat in the September-quarter and I apologize if I missed this in the prepared comments.

But any discussion around the Fed?

It seems like you had decent success in that vertical as well.

Yes I think the -- all of our U.S. government vertical, which is the vertical that we previously disclosed, had a good quarter.

We were pleased with it.

And I do think that there was a little bit of -- I think the U.S. fed part of that business, which again is a subset of our total vertical, and did well in the quarter.

Our next question is from Melissa Franchi from Morgan Stanley.

A question for Ken or Keith.

Just wondering if you can maybe comment on what you're seeing in terms of sales cycles.

So on the one hand, it seems like it's a very healthy security demand environment, you're seeing good refreshes.

But on the other hand, you're now selling a broader suite with the Security Fabric that might require a broader rethink of the security architecture.

So I was just wondering if that's creating maybe a little bit of elongation in the sales cycle.

I agree, it's worth the point.

We do see a customer take a little long time when they consider multiple solution, multiple product need to be working together.

But also that is going to make the deal also larger.

And also, we have to train both our sales force and partner how to sell multiple product and make it all working together as a Fabric solution.

It's a market point trend for this time, the refresh cycle.

Yes, I think we feel very good about the sales cycles I mean, there's -- again, because we have success in both the SMB, the channel carriers as well as enterprise, looking at the numbers for the quarter, I don't think that the elongated sales cycle was the issue.

I certainly do see us building things in our pipeline that are, I guess, I would call longer term or perhaps, larger dollars, but those are much further out.

Okay, great.

And then just one quick follow-up for you, Keith.

You mentioned the contract durations this quarter was up just a little bit year-over-year.

I think 1-month.

How should we think about how that trends for Q4?

And then any visibility into 2019 from a contract duration perspective?

Yes, I think, not something I would normally guide to.

Let's say, and I think previously, I've talked about to you that we would expect that contract term would pick up during the year.

And I think that's probably going to continue on for the fourth quarter.

Our next question is from Gregg Moskowitz from Cowen.

First question is for you, Keith.

This quarter, FortiGate billings grew very well, and they continue to hover around 75% of total.

And I know that you're not yet providing guidance for next year.

But just from a high level, how should we be thinking about the mix for FortiGate versus not FortiGate over the next 12 months or so?

Well, as I think about look back over the last -- for this year at least, that this pretty much kind of hovered in that similar mix, if you will.

We are very pleased with the FortiGate Fabric platform, and we will certainly continue with that as a key point of our strategy throughout 2019.

Yes, the non-FortiGate grow a little bit faster than the FortiGate.

But interestingly, now we offer SD-WAN within the FortiGate.

We started getting to some, the infrastructure solution deployment, which have the security design in.

So that actually will help in the FortiGate side.

We are not quite sure what is going on.

But definitely, we see the non-FortiGate so far this year they grow faster than the FortiGate.

But SD-WAN may changing this a little bit.

But overall, we do see this will also bring additional service and also make the total solution better, stronger and because as the marketable solution all with the customer is also making it more stickier with the customer.

Okay, that's helpful.

And then, Ken, how should we be thinking about the timing of the next ASIC product cycle for Fortinet?

It seems pretty close.

I think for the -- within the next few months or a few quarter.

It's very close now.

About every quarter, we do refresh some of the products like some of the middle range, some of the -- and also we do have last year, we have what we call a CP9 come out last year, which is improving SSL encryption quite a lot.

It's more like a 15x improvement.

So that's a huge advantage when you're trying to deploy the cloud access.

So working good for it both on the cloud and on the edge.

Our next question is from Michael Turits from Raymond James.

Michael Turits from Raymond James.

Ken, for you.

Back to the cycle question, there is some concern about a fall-off in IT spending overall into 2019.

Are you starting to see anything that would suggest any hesitancy in terms of buying as people exercise some caution regarding the macro economy?

Yes, we do have a little bit concern in the last couple of months that is -- but we don't see the security.

Security within IT spending keeping increase.

So even the IT spending flat, we do see the security still would keep growing like a 10%, 15%.

And that's also, I believe, the next 10 plus years will reach $2 trillion market because security get more and more important for all the business we're doing here, all connect together.

And also plus the additional like IoT, OT security and the plus the cloud, some other part.

We do see the overall security spending is not decreasing but keeping similar pace in the last like 20-some years.

And then, Keith, can you talk a little bit about the specific things that you've been doing in the channel and in the field in general in order to help move Fortinet up market?

I know that you talked about increases and incentives to sales a little while ago.

Can you be specific about where you're with that as well as what you're doing in the indirect channel?

Yes, boy, this is -- a lot of credit goes to the sales team, I think, for their execution, together with support from the marketing team and the R&D team.

So I'm not sure if that's -- if you're asking about comp plans specific, yes, I think we talked previously that we did create a separate commission element for products in the second quarter.

I think more importantly and specifically with the comp plans, one thing we did in the U.S. at the beginning of this quarter is we actually took the next step and separated the SMB business from the enterprise business in terms of how those compensation plans work and who is responsible for it.

And I would say, I was ecstatic with the results on both ends of the spectrum.

The SMB channel in the U.S. did extremely well.

And the enterprise in the U.S. did extremely well, too.

I think there's just -- those teams performed exceedingly well.

We got a little lift in productivity probably from that.

And as we've talked before that expect -- I don't see us separating the company.

But I do see us continuing with our focus on how we go to market with these different segments and continuing to invest in both.

Our next question is from Brad Zelnick from Credit Suisse.

And I'll just say that I continue to hear great things in the field about the Security Fabric message and the product offering, as well as your SD-WAN product, it sounds like it's really gaining great traction.

But my question -- it's easy to see why you are gaining share in the market as a result of that.

But my question is actually around Security Fabric on Azure, which Ken, you mentioned in your prepared remarks, and I know it's only about a month or so ago that you announced the expansion of that offering to include more of the Fabric components.

I'm curious, and I know it's early, but can you maybe comment a bit about how you see customers embracing your offering versus the native capabilities within the Azure platform itself such as Azure Firewall service, for example?

We have the approach more like a hybrid solution.

And that's where like a customer has the freedom whether he deploy our products on their premise or some data application go to the cloud.

For the Azure, the same thing.

We have also the broadest security cloud offering whether on Azure on AWS, and some other like Google, Oracle, IBM some other cloud.

So that's where we -- we want to offer the broadest, the best solution, which customer can select how to best fit their need and also offer the flexibility to transfer between -- changing between whether on-premise and also on the cloud.

So that's different compared to some of the native cloud provider offer some of the security service, which they're more focusing in certain application only.

It's not based on the networking side or the infrastructure side.

So that's where we are not competing with them.

It's more like a different layer of security.

So we are more on the infrastructure layer on the network side and our competitors there are more focused on certain application.

I appreciate that color, Ken.

And for Keith, in your prepared remarks, you talked about the impact of tariffs on certain aspects of the results.

And I think intra quarter, you might have commented on this publicly.

But can you just spell out for us exactly what the situation and exposure is to China trade tariffs?

Yes, the headline would be -- it would be less, in Q4, would be less than $300,000 of impact, probably significantly less.

And in Q1, the January 1 date, it will be less than $500,000 on a quarterly basis to COGS.

Our next question is from Ken Talanian from Evercore ISI.

I was wondering if you could rank your success in the enterprise by geo and then separately by vertical?

I think I commented -- it's getting a little specific.

I'd probably go back to the comments I made a moment ago, that I thought the U.S. did exceedingly well in the enterprise segment of the business in the third quarter.

And I'm really, really pleased with what they did, but I think going into the next level of detail is probably where I would pause.

Okay.

And I guess, you mentioned folks are making multiple purchases over time.

Are you booking but not invoicing deals?

And does that essentially give you some more visibility into future results?

I would still put that as a more of a pipeline discussion, if you will, it just moves closer and closer to the close rate.

But I'm not sitting on a large backlog, if that's the question.

Our next question is from Walter Pritchard from Citi.

Just a quick question to follow-up on an earlier question on the long-term deferred.

Can you help us understand how much of that is macro-related?

The customers feeling better about budget.

And how much of that is a factor of the mix into the enterprise?

And in terms of what could drive that to go higher, what would be the drivers from here?

It sounds like that's your expectation.

Yes, I think that if you look at enterprise -- this is Keith, I'm sorry.

If you look at what I'll call the incumbents in the enterprise, you are probably seeing contract terms that are closer to 3 years.

We're obviously at 26 months, as I noted.

To the extent that we continue to have more and more success in that enterprise segment of the market, I would expect that their buying pattern, and we had talked about this before, is such that they're going to want to do 3-year contracts and in many cases, they are going to want to do 5-year contracts.

So I think that's where the pressure comes from.

It is lined up with the success of the push into the enterprise.

And then can you comment on the fabric around things like Endpoint and e-mail.

You haven't mentioned those.

It sounds like it has been SD-WAN and switching and so forth in wireless.

But how are those products doing?

Things are going very strong, and it's part of the Fabric solution.

We do see a similar growth.

It's a pretty, pretty good growth.

I think mail specifically, let me check my numbers real quick, I think mail had a very good quarter.

I would just put that in the tier right below Access switches, Analyzer and Access endpoints, which is in Analyzer.

Yes.

But also the endpoint and also, the SIEM and also, the acquisition we have for the ZoneFox also will help in Endpoint and we're seeing growth.

At this time, I'm showing no further questions.

I would like to turn the call back over to Peter Salkowski, Vice President of Investor Relations, for closing remarks.

Thank you, Gigi.

I'd like to thank everyone for joining the call today.

And let you know that management will be presenting at the following technology conferences during the fourth quarter.

I will be at the UBS Conference here in San Francisco on November 12.

The NASDAQ conference in London on December 4, and then back to San Francisco for a December 6 conference with Barclays.

We look forward to seeing all of you at those conferences.

If you have any follow-up questions, please feel free to give me a call or send me an e-mail.

Have a great rest of your day.

Thank you very much.

Ladies and gentlemen, thank you for your participation in today's conference.

This concludes the program.

You may now disconnect.

Gartner, Magic Quadrant for Unified Threat Management (SMB Multifunction Firewalls), Rajpreet Kaur, Claudio Neiva, 20 September 2018

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