Fortinet, Inc. (FTNT) Earnings Call Transcript & Summary

Good afternoon, everybody. Thanks very much for joining us to the Fortinet fireside chat. With me on the line, I welcome, Ken Xie, Founder and Chairman and CEO; and also Keith Jensen, the CFO, and we're going to be speaking about the fundamentals of Fortinet. I plan on taking the discussion from a very high level at the beginning and then dig deeper as we go through the call. As always, there is a chat room through the webcast that you can ask me questions there if you have anything, and I'll ask -- I'll forward them to management -- I'll ask management these questions. So with no further ado, I want to first welcome you guys for joining us today. Thank you so much for doing this, and I want to start with high-level questions.

You are outgrowing the industry. You're growing so fast, and it's surprising that it's coming not from a company who is SaaS-based or it's coming from a company that is selling appliances with services attached to them and services stand-alone also. What is the secret? What's the reason beyond your high growth? And what kind of value do you bring to the market that leads to this high growth?

Tal, this is Keith. And before I let Ken answer your question, our legal team has asked me to continue reading the safe harbor statement as we always do, which appears on Slide 2. So I apologize for this brief interruption. Just quickly to say, I'd like to remind everyone that we may make forward-looking statements during today's fireside chat. These forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those projected in these statements. Please refer to our SEC filings, in particular, the risk factors in our most recent Form 10-K and Forms 10-Q and to other reports that we may file from time to time with the SEC for additional information on factors that may cause actual results to differ materially from our current expectations. 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. And with that, I hope to give you much better content going forward.

Now we're all clear.

Yes. Tal, thanks for the good question. That's how we were thinking when we started Fortinet 20 years ago, how we can differentiate from other competitors. So that's been the strategy we've been doing for the last 20 years. It's really more investment in the long-term technology eventually can benefit the whole space. So that's a 2-piece differentiation. One, from day 1, we started to develop ASIC chip for the network security because network security handle all this kind of new traffic, new application or its content. They need much more computing power compared to networking routing and switching. So that's where ASIC was helping at additional computing power and also lower the computing cost, and at the same time, can easily add additional function and follow ASIC Moore's Law. And so that's worked for us quite well. So that's why for any function, we have much better performance on average, probably about 10x better than the competitor using software approach. At the same time, we can keep adding additional function into the ASIC chip to process all these additional feature, function there. And so that give us huge advantage both on performance and additional function, more security and also the cost level. So that's, like I said, we started add SD-WAN function, we started add this Wi-Fi security function and all this 5G function. And at the same time, maintain much better performance, low cost. That's always the advantage because we do believe, long term, we call it secure-driven networking. So that's where network is secured and need to be combined together, route traffic not just based on IP address equally -- all this connection, but it's really you have to differentiate based on different application, the content, the user, the device or the region. So that's always the thinking behind. And then the second part also, we have a pretty strong R&D team. So we do see the security issue, the number one is really how to make management easy. So that's where we call the fabric approach because in the past, most security -- different part of cyber securities are not quite designed working together for different companies, different products, so that's where we have this fabric platform, which is designed for 20, 30 products from network security, endpoint security, authentication, all these other cloud and all need to be working together. So that's why from day 1, most of this product developed internally, integrate, automate together so to make it much easier to manage. So that's the other advantage we have. And at the same time, we also tend to be, like, stay in touch much closer with customer, see what's their need, especially also the technical customer from carrier service provider and make sure we can address their challenging need and then keeping invest in the R&D long term, make all these -- both the product and the company better and better. I think, Keith, probably you have anything to add?

No. Very good.

Okay. That's great.

Perfect. So I want to maybe start with kind of a question about the market. I've been asking other companies as well the same question. In the last -- and it's less relevant for Fortinet because you've been reporting on great trends, but it's nevertheless very important for Fortinet. In the last few quarters, the firewall market showed clear signs of deceleration. The market itself went from double-digit growth to low single-digit growth. What's the outlook? And what do you -- how do you -- first of all, talk about the market. What's the outlook? What is driving the market? And how do you see it going forward? And then talk about maybe Fortinet, how do you see yourself within the market and your ability to continue and gain share?

For the network security market, we have not seen slowdown and still maintain -- like I've been in this space for about 30 years. It's keeping around like 10% growth year-over-year. And at the same time, you need to address the new challenge, the new function. And that's where -- like there's all this company grow faster than kind of stop or disappear. But for us, really, how to stay closer with customer and how to keeping deliver the new function, new innovation is very important. And I see some competitors more dependent on acquisition to stay -- keep up the change in the market, which I feel is kind of dangerous or challenging because if you depend on acquisition, then the integration always more difficult, how this new acquired product or technology or even team working with existing one. Because security, if you cannot integrate, the management cost will be much higher. And at the same time, you also kind of slow down the internal innovation, which we also try very hard to keep up all the innovation. That's where most -- the product we all develop -- sell is all internally developed because we -- innovation is one of the key culture. We kind of maintain the current Fortinet team there. So that's where we see -- overall, the network security market is still very, very healthy, especially, like I said, they expand into the networking area because security-driven networking, including SD-WAN, including Wi-Fi security, so -- and also how to make different part working together with endpoint, with cloud. It's kind of fabric platform approach. If they can keep up the change, probably they'll not see a slowdown. If they still stay in the traditional function, just like 10, 15 years ago, the traditional firewall, VPN starting dying, being replaced by what we call the next-gen firewall or the UTM, which has to add like intrusion prevention and antivirus into the traditional firewall and VPN. Otherwise, they cannot keep up with the change. So the market doing the transition, but the total addressable market in network security, especially whether the gateway or go to the cloud or this virtual version, they'll not slow down, and they'll still maintain pretty healthy growth, but has to be address additional challenge, additional function.

Got It. We see your competitor, Palo Alto, shifting to SASE and trying to build a new platform, making acquisitions in this space and trying to transition the company such that a few years down the road, it will be more of a Firewall-as-a-Service company focusing on SASE. What is your strategy? How -- first of all, how do you address new market opportunities, if you can identify the market opportunities? And what is your overall strategy in going to the next phase?

Keith, go ahead.

Yes. I'll just -- I think there's some -- there will be no garden, to coin the phrase, of SASE, and I think that SASE is not a product per se, but more a suite of solutions. And one of those solutions includes SD-WAN as well as a robust portfolio of software solutions. And just as a tangent, I would offer that the software part of our product revenue line continues to grow very dramatically, outgrowing virtually anything else in our suite of products. But I'll kind of hand it back to Ken just a little bit to talk more about SASE specifically.

Yes. Actually, that's where SASE is a new model starting to show up in the last 2, 3 years. It's helping the company, especially enterprise, to ease their management and also address certain mobile device and security. We do have our own solution to address SASE, but we also probably more prefer working with a partner like -- the number one market for us is really the carrier service provider. We do have some other kind of SASE partner, also leverage some of our product technology. So we prefer to partner with them because obviously, there's -- a bigger part is really how to help them manage, become kind of OpEx model. But we do have all these technologies to address ourselves. It's really -- we see what's the current high priority for the team and then how to address the customer need. So at this stage, we feel partner will be better than try to attack this market or address something like directly ourselves. But the technology-wise, the product-wise, we are well covered, and we just try to see what's the best way to helping the overall market. And yes, I agree, SASE is a new -- it's part of the new changing. But so far, the market is still not quite large enough yet, and it's not fit for all the customer type. And some type of customer probably better to SASE compared to some others. And at the same time, there's a big amount of service provider have their own kind of data center facility, the team and with customer, whatever, long-term relation also can be better positioned to address that also.

Got it. So Keith, if I look at your revenue growth and I look at your superior performance, can you break it down for us? Can you tell us what are the areas where you're growing? What are the successful initiatives you're having? What are the areas you still need to further invest, just to understand the composition of growth?

Yes. It's a very good question, and probably a lot of different ways of looking at that. One way of looking at that has been the effort on our side to expand into the -- continue to expand further into the enterprise segment while maintaining our dominance in other segments of the business. And that -- those numbers that we've talked about periodically, particularly the G2000, billings growth, those very large companies -- since we've been providing that information over the last 2 years, that number has always been higher than the growth of the rest of the company. And one key metric that we talk about there to enable that growth is our sales coverage ratio. If you look back at us a couple of years ago, our coverage ratio may have been -- a rep had on the order of 60 or 65 accounts assigned to them in the U.S. If you fast-forward to today, we're below 30. And we view that direct touch as something that's very important. At the same time, it's important in our go-to-market strategy with our channel partners. So it's a partnership with our channel partners. It's not at all instead of our channel partners. SD-WAN has -- looking at other growth drivers and contribution, SD-WAN, which is a use case for our firewall because the functionality is embedded in our firewalls, but we have seen some dramatic growth in that. In a 1-year time frame, say, from the beginning of 2019 through the end of 2019, we really didn't appear on the radar screen with SD-WAN market share anywhere. I think we exited the year in the order of 10% or 11% of the market share. I'm being shown 9%. I'm exaggerating, I'm sorry. So 9% market share at the end of the year. That's a very dramatic growth curve, and it's -- when we look at our pipeline, we would expect that the SD-WAN would continue. If you look at the mix of products and services, another way of slicing and dicing it, we have seen over the last several years that the mix has continued to shift from product to services, and that provides a tailwind for us on the margin because, obviously, the services come along with not only more predictability to our business model, but also a higher margin. We have very good diversification across our business, whether you look at it by customer segments, let's call it, enterprise, mid-enterprise and SMB, all kind of weighing in at about 1/3 each of our business, or whether you look at verticals. In addition to the telco, carrier history that we've had with a tremendous amount of strength, international, government and local government has shown to be very strong over the last several years and especially so recently, together with financial services. And technology is continuing to knock on the door, trying to get into that top 3, if you will, of our verticals. On a geographic basis, we're perhaps a little bit unusual for a U.S. tech company in that the majority of our billings and revenue comes internationally. Our U.S. -- pure U.S. business runs about 25% to 30%, and that's probably on the low end when you compare it to other benchmarks. But on the positive side, it gives us a very high level of diversification. I've shared the metric previously that we have -- I believe it's 80 different countries. No one country represents more than 3% of our total billings. But in total, those 80 countries represent 50% of total billing. So it's really that diversification part of our business model, whether it's by country or by customer segment or by vertical.

Got it. Then -- so a lot of the growth is driven not only -- of course, you have new products, but a lot of the growth is driven by your go-to-market investment. And you -- as you noted, you went into new customer verticals and new countries and you addressed -- what's the outlook? Do you need to further invest in go-to-market or is the focus now shifting back to product? You've always invested in products, but there was a focus on go-to-market as well.

Yes. I think it's clearly going to be both, right? I think that Ken made the comment at the very beginning that -- I would describe it as we've historically been a build versus buy shop. And I think we've been extremely successful and -- substantiated by Gartner Magic Quadrant's and NSS Labs' recommendations. We're extremely proud of our engineering team and the products and services that they produce. I don't see any significant change in the business model in terms of our enthusiasm for continuing to invest in R&D. And as you kind of alluded to, you need to continue to grow and invest in the top line on the sales and the marketing and the go-to-market. And I would expect that we would continue to do that. And largely within that framework that we've talked about before, which we describe as balanced growth and balanced profitability.

Yes. Totally agree with Keith. I think he like to hear this, it's really -- we always want to balance healthy growth and profitability. So that's where I believe since IPO, every year, we have GAAP profit because in the security space, we see quite some other companies that are losing money on a GAAP base, losing a lot of money, just all about growth. But I do believe we need to be -- maintain both, healthy growth and also we can invest in the long-term technology product-wise and address both on the go-to-market and also the R&D part altogether. So that's what give you more long-term advantage instead of short-term rush growth, losing money or gain some share and then eventually have to changing or adopt a new [ stance ]. So that's where we kind of always keeping this balanced healthy amount, both growth and profit and also to invest in long-term R&D and also the go-to-market strategy.

Got it. So Ken and Keith, you -- if I go back a few years, you started as an appliance company, if I can call it this way. You invented the term UTM. You used your hardware capabilities in order to add more and more services. And we see this -- we see you continue to evolve in this way. And SD-WAN is a great example. You've added SD-WAN capabilities to your hardware or your software on the basis of the platform. But there's also now -- the market is developing for SaaS-delivered security. What are you doing on the SaaS side and what opportunities in the market are you addressing?

Yes. I do -- you can see in the last like 10, 20 years, we call -- also Gartner also have the similar kind of trend. So the cloud and mobile starting to replace the traditional server and the PC and -- but also going forward, the edge computing also was starting to replacing the cloud and also mobile with edge computing, immersive wearable device, all these kind of things. So that's where for us, the ASIC always -- so far the reason to invest in ASIC from day 1 is we do believe you need to leverage all the technology, all kind of control, manage all the technology to address the network security need because the most network security company or most security company from the beginning, they are most software-based company. And that's also my first company is the same thing. And then I realized if you have to depend on other people to develop the server for you, to develop the OS and then you do the application and -- that probably has a lot of limitations. So we would rather to manage from hardware, from ASIC level together with other infrastructure part. So that's where in the last 10 years, the cloud infrastructure developed a lot. But I do believe you need to have both, right? So whether you address the cloud and at the same time, going forward, edge computing. And even with the cloud, you also need to access the cloud. So cloud is very interesting. We did a study, in the last 10 years, even the cloud security added quite some additional business, but they have not slowed down the on-premise in our appliance-based business yet. And that's just keeping additional need to address. And at the same time, we -- the reason we have SD-WAN is not by accident. It's really we -- from the very beginning, we do believe networking security need to be designed together because secure-driven networking. So if you look at 10 years ago, we started to integrate Wi-Fi security into FortiGate. But that [ turn always ] in the Wi-Fi space just a little bit smaller compared to what we have now in SD-WAN space. So -- and also Wi-Fi ramp-up rather quickly 10, 15 years ago. But we do see that since starting coming back, the company that deployed Wi-Fi as a separate infrastructure security starting to see the benefit of management together into one FortiGate infrastructure. And so SD-WAN, we kind of cutting the right timing and also the right size the Fortinet have more impact in the space. But we also have the 5G security working now. We also have, what we call, internal segmentation, go into the internal LAN switch market. So using FortiGate to manage all these switching, networking all this together. So we call the FortiSwitch also see starting ramp-up rather quickly. So all this, I think, fit in the overall like combined networking security together because secure-driven networking quite well. So it's the company strategy from very beginning, and also ASIC fit quite well into this strategy. That's where cloud is a part of the infrastructure. So we do see that part of business doing well, grow very fast. But in -- but it's feeding the total solution, the cloud, the endpoint, the networking appliance side and combined with other like SD-WAN and internal segmentation, Wi-Fi security is a total, we call the fabric approach. And at the same time, make sure they can integrate, they can automate. So that's the part. I do see if they only -- some company only address the cloud side, their market will be limited, right? So that's probably -- it's a little bit more fit for some software company if they don't have the hardware capability, and they don't have some other product -- different part of infrastructure, it's more easy for them because software can either apply the cloud and then have other provider to the infrastructure part for you do the hardware part for you. But on the other side, I do believe long-term wise, some of these cloud provider can easily get into the cloud security themselves. Then that time will be -- this cloud security company probably will be a little bit challenging and more competing with this cloud provider, which the only infrastructure, they have a much better -- whatever cost or kind of a way to expand it among their cloud customer base. So that's the part because we feel if we can address the total infrastructure, we can leverage what the advantage we have like the ASIC part, the long-term investment, a different fabric part to integrate, automate together. That can lower some of the risks some other infrastructure player may get into the security space.

Got it. So SD-WAN is a big driver today. Can you envision the next cycle? What's going to be, in your view, the kind of the big areas you're going to be investing in or addressing over the next few years?

Yes. SD-WAN is growing very, very fast. It will be about 50% growth year-over-year. Last year, probably around $1.5 billion, probably 3, 4 years will be reached like $5 billion. So still long way to go. We still see a lot of potential growth. But also, like I mentioned, we're starting to see Wi-Fi security, like using SIM FortiGate, did not only offer the SD-WAN, but also Wi-Fi security as a Wi-Fi controller. At same time offer, we call it, 5G security also building in the same FortiGate platform. And plus the internal switch, internal segmentation is all working well and leverage the computing power we have from our own ASIC together with the latest CPU. So we're too using CPU. We're too using software. That's no mistake. It's very -- any software function we have has the same function, performance than any other software company, but the ASIC is helping boost the performance of traditional CPU, like easily by 10 to 100x and at the same time, free up the CPU to run some new software function. So that's why we do see not just SD-WAN growth, but the 5G is starting to see ramp-up pretty quickly. And also the Wi-Fi security starting to come back, they see the advantage of managing both Wi-Fi and security together, especially within enterprise. And at the same time, they're also starting to get into the traditional internal switching market, we call it internal segmentation, to secure the server, secure the department and even secure particular user is starting to see a big ramp-up.

Got it. I want to switch gear to another product, the fabric strategy. Can you explain, first of all, what it is to those who don't know your solutions well? And how does it help you to grow in the edge environment?

Yes. That's we call the fabric because it's been -- it's including like 20, 30 products. So most are internal developed from day 1 in the last 20 years. Like we have our own endpoint, we call it the FortiClient. So we have email security, we call FortiMail. And FortiWeb, web security, web-secure gateway. And also we own cloud solution. And also with all the other, we call it FortiToken authentication and the sandbox and the DDoS attack. All these need to be working together to address different part of cybersecurity infrastructure. So that's where like -- today, most of the company, they have different products from different companies around different parts, like how endpoint working with network security, working with email security, web security and internal authentication. And it's all come from a different company, different product, different vendor. They are not designed to working together. So that's where our fabric approach, we have all this kind of weaved together, make it one part, easy to manage. So you have to be able to manage, integrate first before you can apply the automation. In security, we do believe automation is angle. You need to be leverage out automation to do all this AI machine learning to quickly respond to all this new attack in real time. But without integration, without like all this fabric platform working each other together integrate will be more difficult to do the automation. So that's the fabric. So we see fabric already like 20-some percent -- 27%, 28%, yes, keeping growing even much higher than some of our competitor claim their cloud company, but there are priced at higher percentage than we are. So fabric, I have also to say probably majority is software also, like endpoint, like some of the web or cloud or whatever. We see fabric growth much faster than the network side, FortiGate side. But FortiGate also has pretty healthy growth. Probably, Keith know the number better.

Yes. I mean, I think the -- before I get to speak the numbers, I think that you're kind of really building on what Ken just kind of laid out. The way we view it is, we've seen a similar situation in other industries where there's been an evolution from point solutions to platforms. I look at ERP, perhaps, and CRM is 2 examples of that. And I think there was a very good publication issued this week on a cybersecurity primer. And if you look through that publication, you'll see that many of the items that Ken just listed off are part of our components of our fabric. It's really the foundation is built on either the appliance or the virtual form factor of the firewall. But the intention and the idea is to continue to add additional functionality either inside the firewall or attached to the firewall. For example, EDR and SIM and endpoint and access points and switches, and most recently, authentication and token. I mean the list goes on and on, but I think you can go through that publication pretty quickly and see what -- very readily what our strategy is related to the platform. As Ken pointed out, we do offer those other products and services in both form factors. By that, I mean as a hardware appliance or, as I mentioned earlier, as a software application, and that is growing faster. That part of the business in total is growing faster than the rest of the business and the software component of it is growing very dramatically.

Got it. Keith, I want to ask you before we run out of time. I want to ask you about COVID-19 and the implications in your view on your business. We have seen companies reporting solid results -- security companies reporting solid results. And investors are somewhat concerned that COVID-19 had an early positive impact on numbers and it brought forward demand and then the rest of the year could be more challenging. We already heard today from a company from a different place, like a different area whatsoever, but they basically said the same thing, that the beginning was strong, but then now it's difficult to get and sign deals and get to the offices of people, even virtual, et cetera. So what's your view on the impact of COVID-19 on the demand for your product?

Yes. I think -- if I kind of go back to some of the commentary that we provided in the earnings call, one, people are aware that we -- with our, I think, sort of a cautious approach and we removed the guidance for the full year. But we did provide guidance for the second quarter, and looking at linearity, to this point in the quarter, that supports the guidance that we've provided out there. To get a little more granular on it, in the call, we provided a lot of data points, we're going to give insights to what we experienced and what we saw. We did see 3 products that are fabric products. We talked about authenticated token and client that outperformed by about $10 million in the first quarter, and we saw that outperformance continue into the second quarter. I want to say a $700 million plus quarter. That's not a huge number, but you can see a bit of a shift of it. When we looked at it geographically, what we expected, what we saw and the actual results in the first quarter and what we expect to see in the second quarter was that geographically, our billings growth would probably kind of follow the arc of the virus, of the pandemic. And by that, I mean we saw a very early slowdown in APAC in the first quarter, and then started to see it come back online as we got into February and March. Europe was then behind them and then the U.S. And as we look at the second quarter, when we're going through the guidance setting process in terms of where we thought we might see above-average growth compared to our own averages, if you will, given -- we expect it to continue to follow the arc of the virus. And by that, I mean APAC and Europe would probably have very good quarters, and U.S. and Latin America would be the ones that would be coming back online as we work through our way through the quarter. I do think that the sales teams have adjusted to the virtual world, if you will. As I went through that, with respective geography and virtual meetings are something that are becoming quite commonplace, if you will. If you're looking at the sales cycle of the technology product, including our own, if you look, particularly, say, at a large enterprise in the U.S., these sales cycles probably span several quarters. And so an interruption of some period of time, whether it's 30 days, 60 days, 90 days or something like that, will probably just kind of work itself out in the wash over the longer term. To the extent that the virus continued on and we have a second wave of the virus, I think that's what gave us pause related to our full year guidance.

Got it. Unfortunately, we just ran out of time. So I want to thank you sincerely for joining us today and giving us your insights about the space. To the investors, if there is any other question, please don't hesitate to e-mail me or call me. And if I don't know the answer, I will -- I'll get the great support of the Investor Relations team to answer it. Thank you so much.

Thank you, Tal.

Thanks.