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

Okay. Good morning, everyone. My name is Saket Kalia. I cover software here at Barclays. Welcome to the Barclays TMT Conference. Very happy to have with us the team from Fortinet. We've got Ken Xie, Chief Executive Officer; we've got Keith Jensen, Chief Financial Officer; and we've got Pete Salkowski, Head of Investor Relations. We've got about 25 minutes together today. So maybe I'll leave some fireside chat for the first 15 or 20 minutes or so, and then we'll take some Q&A from the audience. Can't ask a question through the webcast here, but if you've got a question, feel free to e-mail me at [email protected] and I'll be sure to try to weave them in at the end. So with that, maybe as a framework, first and foremost, thanks so much for being with us here today, guys.

Thank you, Saket.

Thank you, Saket.

Mr. Salkowski, I think I wanted to kick it over to you to maybe start us off with the safe harbor.

Yes, just real quick. Thank you, Saket. I'd like to remind everyone we're making forward-looking -- we may make forward-looking statements today 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 Form 10-Q and some other reports that we may file from time to time with the SEC for additional information and 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, back to you.

Excellent. Excellent. Thanks for that, Peter.

Ken, would love to start with you. It's an interesting 2020 to say the least, and COVID has certainly had some short-term impact to all of our networks, right, with more work-from-home traffic. I guess the question is as you look forward to the next few years, what long-term impacts do you feel like COVID is creating for your customers' network architecture? And how do you feel like Fortinet is participating in that?

Yes, I think the industry kind of have been in the security space. I mean it kind of benefited a little bit, whether work-from-home or some other, there's more increased tech surface. And at the same time, certain like vertical space like certain retail or restaurant whatever, they are accelerating some digitalization. And also company do see the need to consolidate some multiple security vendor into less the better, so they can lower the management cost because IT under huge pressure right now, try to manage all these kind of work-from-home or other remote access job there. So we also see some service provider play a more important role, especially some kind of a cloud-based remote managed service provider because service provider keeping one of the biggest sector for us. So we still see the increase in service provider and also some government spending also kind of starting more involved. We see uptick of government spending also. So that's where, I think, all these changes probably will benefit, a little bit bigger security provider. And also if they can keep up the innovation, keep up the internal organic growth, we do see some more merger acquisition going on now. But also, I have to say, if merger acquisition, they kind of a little bit more benefit short term. Long term, most of them have some challenges to integrate and to keep up the growth after a few years, right? So that's where we're worrying Fortinet also try to insist, "Hey, we need to keep up the internal innovation, keep up the change in the space." That's a very important path for long-term growth.

Got it. That makes a lot of sense, Ken. Keith, I'd love to kind of ask you a similar question, but I think it's a similarly -- just as important question, especially today, and that is the COVID benefit on Fortinet's business, right? And so the very specific question here is, did COVID result in any pull forward of business in 2020? Or any other benefit in 2020 that you feel won't repeat in 2021? And again, I'd emphasize just for those folks listening to the webcast, I think this is a really important question that I want to draw everybody's attention to. So Keith, all you.

Yes. Saket, thank you, and thank you so much for teeing that up at the way you have. I think we've been very transparent in terms of the COVID benefit that we could quantify and that was specifically 3 products that are fabric products: Authenticator, Client and Token. In the first quarter outperformed on the billings line about $10 million. And we said that at that time, we expected that, that to kind of diminish as the year went along. We came back in the second quarter noted that it was about $5 million and has continued to diminish beyond that. When we look back at Q1, Q2, Q3, I would describe Q1 and Q3 as being fairly normal in terms of puts and takes, where you end up at the end of each quarter as you exit it, some deals come in a little bit earlier, some deals get pushed out to the next quarter. And I think that Q1 and Q3 were fairly balanced in terms of the net position. Now the descriptions around them in a pandemic world can be quite different than what we've seen historically, but the net effect was about the same. Q2, I think we commented previously, it was more about a pushout net, that there were deals that were teed up in the second quarter that we thought were going to come in. And actually, those were -- some of those pushed out to us. It was a net negative for us. I would guess that some of this commentary that we're hearing about pull forward, what have you, it may lend itself if you're a company that's focused in the U.S. enterprise space because that's probably the space that had the idea and the capacity to buy more, if you will, during 2020 and taking opportunity away from 2021. If you overlay that with Fortinet's business model and its customer mix, it doesn't become intuitive. By that, I mean the SMBs and the mid-enterprise, which represent probably 2/3 or 3/4 of our business worldwide, are not likely candidates in the period of recession to deploy capital for future growth. And we did not see that, right? If you look at the U.S. enterprise part of our business, probably 10% or 15% of it, they're -- we're not aware of any early buying in that space. And if it did exist, it would be de minimis. By the same token, if you look at it geographically, right, if you move outside the U.S. and you account for the fact that 70% of our business is outside the U.S., again, not a logical place that you would see early buying. So to emphasize the point, we don't believe that we've seen a pull forward from 2021 into 2020, and we don't think it's intuitive when you look at our customer base and the size of customers that we deal with.

Got it. Got it. Very helpful there, Keith. And Peter or Ken, if there's anything you want to add on to that, please feel free. Ken, maybe staying on the network security part of the business from a high level, I think another important question is this idea of a refresh cycle. One of the questions over the last couple of years has been this idea of a refresh cycle in the firewall space. And hopefully, most people remember, I mean, you go back a long time in the firewall space going back to NetScreen, you've seen several refresh cycles. The question is where do you see this industry refresh cycle currently, especially given COVID has sort of changed a lot of spending plans? Where is Fortinet in that refresh cycle, if you will?

Yes. First, the refreshing cycle impact for Fortinet is very, very small compared to some other player competitor, whether like Cisco or Checkpoint pullout because refresh cycle more apply for the enterprise, especially more U.S. enterprise, which Fortinet is still a relatively small market share and has a lot of room to grow. It's more opportunity for us because when the refresh happen, we do see the customer also open up the bid and have some other more vendor try to come in to compete. So -- and then on the other side, I do agree the pandemic kind of make a refresh cycle, maybe drag long a little bit longer than normal and also companies starting to consider how to secure the whole infrastructure instead of just the traditional border firewall. And that's why we're keeping pushing, we call the security-driven networking. So the firewall need to be expanded into the WAN side, like SD-WAN and 5G. They also need to expand internally, like the internal segmentation, the WiFi security and cover the mobile work-from-home. So that's where we see since changing in the enterprise. We feel we have pretty good position and opportunity to keep expanding there. But so far, I have to say, the refreshes have no impact or maybe more positive impact for our business because more broad offering, combined security networking together and also because the high-speed ASIC advantage, they go to internal high-speed inside network for the segmentation, for the WiFi, for inside the data center. So we do see kind of the changing trend fit for net quite a while.

Got it. Got it. Very helpful, Ken. Keith, maybe for you, maybe digging deeper into the FortiGate business. You've spoken about this a couple of times this year, just around this idea of less discounting than you've seen historically. And I'm curious, what do you think is driving that? Is that perhaps greater adoption of SD-WAN that's helping that in your view? Or is that something else maybe that's happening across the industry? Anything you could speak to on less discounting?

Yes. I think for Fortinet specifically, I would just respond by saying much better execution. And by that, I mean, I think that we've always been coming into the conversations with a pricing advantage. And I think our competitors are more often than not forced to come to meet our price as opposed to the other way around. And the execution part of that is making sure that we, as an organization across all the different departments, clearly understand that pricing advantage that we have, whether that's the sales team, the finance team and what the engineering team has created for us with our cost advantage. And if somebody comes to us, for example, on the sales side, and there are occasions where discounting comes into play, obviously, but I think our question back to our salespeople is you should have already won on pricing, right? If you're not winning the deal, then maybe there's a different reason. Now in certain geographies with some other players and firewalls, pricing really can become a conversation. But when we look at the large players in the space, we should have already won on the price, and we should be able to move away from discounting as a lever to get the deal done.

Got it. Got it. That's helpful. Ken, I touched on SD-WAN. Obviously, a very successful driver here for over a year, if not close to 2 years here for Fortinet. But I'd love to ask about this idea of the branch office going away or shrinking more realistically as a result of COVID. I think some bears have argued this. And to be honest, it sort of feels reasonable to think that your enterprise customers may want fewer branch offices and, therefore, potentially fewer firewalls as a result. What do your customers say about that? What do you think about that?

Saket, I agree with you that the rental, especially the branch office seems to slow down and -- but on the other side, like when most people starting to work from home, we see many companies, they also want to expand. They call the home branch or home become a new branch kind of concept. Because when you have all these like finance service adviser trigger this starting working from home -- trading from home, not only security but how to guarantee the quality of the service and other parts of the selling are more important. So we do see some expanding like from the branch office to the home, working environment like some companies starting to pay employee a broadband access, the firewall, manage their traffic, quality control I'm not really affirm, but we do see a lot of finance service companies starting doing that to make sure when people work from home, they can maintain the quality, the securities and a lot of other requirements there. So that's actually kind of helped us see some kind of a low-end unit growth. It's pretty interesting. So instead of what they're expanding the branch office, they're now kind of using home as a new kind of branch concept. And also combined with SD-WAN, some other technology, the 5G also come up, we do see kind of a -- they kind of address more broader, bigger, wider infrastructure now compared to just cover the branch office.

Got it. Got it. That's interesting. Keith, maybe staying on that topic. I think the common thought is there's "a lot of branch office business at Fortinet." And I think that comes from kind of looking at that mix of FortiGate, FortiGate by lower end versus higher end, which may or may not be correct. And so the question is for you, Keith, how do you sort of size your exposure to the branch office?

Yes. I think I'd probably build a little bit on what Ken just commented a moment ago and make the point that internally, we track about 13 or 14, maybe in 15 different use cases for firewalls, branches being one of them. And yes, we've done well and we continue to do well with branches. Ken brought up one example. We talked a little bit about SD-WAN, right? And I think that's kind of getting into play there. When you look back at our prior performance and then talk a bit about our future performance in SD-WAN, if you look at SD-WAN in 2018, we had basically no market share. We exited 2019 with about 9% market share. That probably translates into something on the order of 5% of our billings in 2019 were SD-WAN. As Ken saw that kind of move along in 2019, he had a goal for us of hitting 10% of billings. And as soon as we got close to 10% of billings, Ken lifted 15% as the new goal. My suspicion is that as we edge up towards 15%, Ken is pretty quickly going to give us a new goal on SD-WAN. And it's the reality is it's about the convergence of networking and security and the ability to execute and play to your advantages. If you look at it, go forward-looking a little bit, and I think pipeline is a very good indicator of where the market is going to go. I would note that probably for several weeks in the second quarter, at SD-WAN pipeline pause, right, in terms of growth. For the first time that we've seen a pause since we've been tracking it. But it's quickly come back online, and we look at where we sit now and how we're positioned for 2021. Early in the planning cycle, we've got to go do things, but we're very pleased with how the SD-WAN pipeline has continued to grow.

Yes. Also some interesting sector like retail, we see pretty strong, very surprising growth because then we did some study. We feel somehow this network security penetration is still relatively low, whether in retail or digitalization. At the same time, overall SMBs still have a very low percentage of network security coverage. So that's where this pandemic actually accelerate some of the -- like a retail, some other SMB, they want to have a more digitalization, more working on security, remote online. So that's where we see pretty healthy growth actually in the retail in SMB.

That's helpful. Maybe just to double down on this point around SD-WAN, I think one of the things that I've always found interesting about SD-WAN is actually the pricing strategy, which is kind of tough to beat with free in my view, right? But I guess, customers obviously have the option of having a dedicated SD-WAN appliance or a cloud service, for example. So why do you think customers want to combine SD-WAN with the firewall? And for those that don't combine the 2, what's their reasoning for having a separate SD-WAN service? Does that make sense, Ken?

Yes. We kind of like combine 3 box into 1 FortiGate. Basically, 1 FortiGate can cover like traditional networking routing, can cover the SD-WAN and also can cover the security. So that's -- and also the benefit of this SD-WAN, really now you can readout traffic based on application. And when you combine security and SD-WAN because security address more than application, they also can look at the content, can look at user, can look at device, can look in the region. And all this has a lot more benefit for the customer when they combine security and SD-WAN together. So that's where they see the huge benefit, not only more secure, also cost saving and more reliable service and more under their control. So that's what we see is very quick, like a triple-digit growth year-over-year for the SD-WAN business right now. I mean secure the SD-WAN -- combined secure the SD-WAN together.

Yes, yes, absolutely. Boy, so much to talk about with such limited time, but maybe the time that we've got left. First of all, I'll just let the audience know if there are any questions you want to ask, just feel free to shoot me an e-mail. But Keith, I want to ask you about a question on COVID again, but actually from an expense perspective, right? And obviously, still a lot to play for here in Q4. So I realize it's maybe tough to talk about 2021 this early. But I'm curious from an OpEx perspective. Can you just talk about how much OpEx you saved this year or points of margin benefit? How do you want to talk about it? How much you saved this year from COVID that is temporary and perhaps comes back to some extent in a more normal environment?

Yes. I think -- great question, Saket. I think that, like many companies, we've seen the benefit of not having travel run through the OpEx line and not having marketing event spending went through the OpEx line. We've talked, I think, previously, that's probably in order of about 1 point to 1.5 points in that time frame of margin savings. But at the same time, we've basically reinvested that savings in growth for the future. And by that I mean, you've seen some of our hiring numbers well over 20%, and that's largely biased towards sales head count. And we're taking this opportunity in 2020 and using that T&E as a subsidy, if you will, to fund sales capacity for growth in 2021. So -- but it will be now that -- as we see that, travel come back online and marketing events come back online in 2021, that should be, at the same time, that those salespeople that we've hired are tenured and more productive than they would have been otherwise.

Got it. Got it. That's helpful. Ken, maybe for you, again, sort of a strategic financial question. As a member of the Board, obviously, I mean, I believe the Board still has, I think, roughly $1 billion in buyback authorization, and you guys correct me there if I'm wrong. So the question is how is the Board thinking about capital allocation here in terms of buyback, M&A or other uses of capital?

Yes. We also want to be like Keith said, we have a lot of discussion. We want to be also financed and efficient, right? So that's where, obviously, the best investment via internal investment for the growth. And then if there's a merger acquisition opportunity, we also look on that. And then if we cannot do the first tool and then actual cash, we want to return to the shareholder. And I mean shareholder or we call stakeholder because every employee is also a shareholder and at the same time, we want to kind of like keeping using the cash instead of leaving the balance sheet too much. So that's where we -- yes, with our cash level, we feel pretty good positioned, whether we do more buyback or invest in the growth.

Got it. Got it.

I think Ken particularly shown that we understand the importance of returning capital to shareholders, right? No doubt about that. But I think we also understand Ken, in particularly, do it opportunistically taking advantage of what we saw in terms of the dislocation in the market in that March time frame, where I think the buyback was about $990 million. That's a clear example of being opportunistic.

Yes. Also, we are probably the only GAAP profit and still growing top cybersecurity company. So we want to keep it that way. That means -- so we're using GAAP measure compared to some other company using the non-GAAP order when GAAP is really losing money. So that means we are kind of -- do consider investor or shareholders are also very important to us, right? So that's where -- if we can be more efficiently using the cash and we're investing growth and improving the margin. If not, then should we go back to the shareholder.

Yes, absolutely. One last question for Keith, and then I want to ask a higher-level question to Ken. Keith, started to jump around here, but maybe just to move up the income statement a little bit. I just want to double-click on gross margins quickly here. We've seen some of the -- some of Fortinet's best gross margins numbers in a few years, if I'm not mistaken. And you've said that component cost has been part of that. Can you just go one level deeper into that? Is this because of scaling the number of units for newer appliances? Or is it something else? Just anything on the product gross margins and what's kind of driven that?

Yes. To frame that up, if you look back at that 2017, 2018 time frame, I think product gross margin was around 58%. And if you fast forward to say the last 5 quarters, we've been easily over that 60% threshold on product gross margin. And I think you're referring to that. I do think, Saket, as you point out, the economies of scale come into play there, no doubt about that. But I think part of the -- what's not well communicated is the benefit of the ASIC, right? And really, what you see through the successive generation of ASICs is the ability to create more capacity to improve the operating system. But it's also the ability to embed certain elements of a BOM and a firewall that were previously stand-alone. And so you're literally taking out elements of the BOM each time you generate a successive generation of the chip. And I think that, together with the discounting and better focus on how we price and have conversation in negotiation, I think those have all really combined to drive that tailwind that we've seen in product gross margin.

Got it. Got it. That's helpful. I think the last question here is maybe for you, Ken. I mean as we all know, Ken, I mean, I think you spent a lot of time with customers. And so one of the things that we're trying to ask all of our companies here at the conferences, what are your customers saying about their overall willingness to spend in 2021? Obviously, kind of a different year in 2020, what have those preliminary conversations have been like for you, Ken, looking out to next year?

I probably will answer together with Keith, and I can cover a few here first. We do see the -- there's some change in the trend in the security and now is a covered whole infrastructure and also make all this different part of our security working together. So that's what we call a fabric. So that's where we see the growth of fabric probably more than double compared to the traditional network security. So the trading and network security, we still see a healthy growth like a mid-teen growth. On the other side, the fabric probably almost doubled, and then the fabric now come close to 30% of total business now. We call fabric, some other may call next-gen or some other one because we do, do a lot of internal research investment, whether in the cloud or in some other part, which may not be very visible to the other side, but we do stay very closely with customers, with service provider and then meet their new demand. And also, we very insist that organic growth is very important for a company to be the leader long term, because once the company reach a few billion dollar like we are today, you can see historic data, whether some other bigger company, they stop organic growth, right? So that's where we -- even we reached a few billion dollars, and we still want to maintain organic growth and like close to 20% or even above that. And so that's very, very important point to be the long-term leader in this space. So Keith, you probably -- more detail, you can see the 2021 better than me and maybe somehow too long term.

A very good vision, Ken. And I'll only double-click on one thing for the sake of time and that is on the platform conversation, the consolidation of the industry. Gartner has got some numbers, as I understand it, that talks about 20% of the companies we're talking about wanting to move to a platform or consolidation strategy with their security vendors. And that number is expected to move to 80% of companies by 2024. And I think it goes back to a comment that Ken made just a moment ago about the importance of the fabric platform and what's in front of us for longer term in terms of growth opportunity.

Got it. Got it. Guys, plenty more questions to ask you, but unfortunately, only limited time. Thank you so much for this. This was a really great session. Hopefully, folks on the line thought the same. But I can't wait to do this here in-person in 2021. So thanks again, and I look forward to doing that, guys.

Yes. Thank you, Saket.

Thank you, Saket.

See you, Ken. See you, Keith. See you, Pete.

It was nice talking to you.

You too.

Thank you.

Thank you. Bye now.