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

Good afternoon, everybody. Good morning for those on the West Coast. Bachman here again from BMO. Thrilled to have Fortinet. Interesting time to be in security. I think Keith wants to go ahead. Peter is going to talk a little bit on the disclosure side, first, back to you guys.

And I think in a moment, you'll see our safe harbor language slide here, and I'll just make people aware of our safe harbor [indiscernible] of our comments today. Back to you, Mr. Bachman.

Okay. Before we get into the questions, Peter, how is the golf tournament looking? Are we still going to be invited with the spread of Delta? Are we still on for our analyst event?

It is. The tournament is -- we're less than 3 weeks away, I think, as I heard yesterday or day before. Yes, everything is good to go. Fortunately, right now, the fires in California are unfortunately, they're all north, but they are far enough away that shouldn't impact the tournament at this point. So yes, looking forward to the opportunity.

Okay. Terrific. I look forward to being there, although surely not playing in the tournament. Let's turn a little bit to -- I will refrain from as I threatened to asking Peter his opinion on the Palo Alto quarter, although perhaps we'll come back to that. But one of the issues coming up, I think more and more is consolidation. And I wanted to ask Keith and Peter about this to start with. And consolidation in security has been talked about for a long time, 10-plus years, you ask any SISO, they want to consolidate and it never really happens. But it seems like things are a bit different at this juncture and there is some momentum towards consolidation. And I just wanted to ask, how do you guys view consolidation at this juncture? And what's the future opportunity?

Yes, I'll jump in and then I'm not sure Peter will ask comments as well. I do think that from a customer viewpoint, you can understand the drivers for consolidation. These companies are being asked in the age 30, 50 even more point solutions, if you will, that are largely unintegrated. And the simple cost of managing that and staying current on the various alerts that come through and responding to them seems to be a very onerous task. And I think, though, to ask any of us in the industry to actually consolidate everybody else with M&A, we'll take a pretty big checkbook that probably none of us [indiscernible] pursuing. And I think that's really why you're starting to see the platform conversation, the journey of the platform conversation take hold. I don't know that it's different than what we've seen historically with ERP and CRM and their journeys doesn't happen overnight. But there's clearly -- Gartner was saying that I think about 25% of companies are now having a conversation about platforms, and that number is probably going to get to closer to 75% or 80% of companies in the next few years in...

And Keith, sorry, within security, you mean?

Within security, yes. And I think people are careful to say it's not going to be a single platform for most companies. There's probably going to be 4, 5, maybe 6 different platforms. And I think for us, that makes a ton of sense. And our strategy has been, we call our Fabric strategy, broad, integrated and automated because when you need a broad product suite, right, to enable this consolidation that we're talking about here. But importantly, it's going to be integrated. That's the pain point for everybody. If you can get those 2 things, then it creates the holy grail of automation that people are looking for. And clearly, our journey has been -- continues to be a build versus buy shop. We will do acquisitions, tuck-ins, things that we are comfortable that we can integrate. Now the Proofpoint, I think, is what we've seen in the last 2 quarters for us with our non-FortiGate business, FortiGate being the firewall, which is the cornerstone and the non-FortiGate being, what I would call the other products that are integrated to it. That mix shift has been about 70% firewalls and 30% non-FortiGate platform products. The growth of those products in the last 2 quarters has been over 40%. I don't think that's a coincidence.

Not much to add, but I will anyway. I would add to that, that the concept of changes in network infrastructure, something that I know Ken has been talking about for the last several quarters, and the concept of security-driven networking, which we've talked about for the last couple of years, and that is security and networking getting closer together, I think all play into the sort of that platform idea that today, companies are looking -- they're looking to how to go to the cloud, certainly in the U.S. more. And in doing that, it's really a change in the infrastructure, changing in the networking capabilities that they have to do, SD-WAN be an example of that to get the data even go to the cloud. And so as they look at this network infrastructure changes, it's actually an opportunity for Fortinet to be invited in to have those conversations. So what needs to change, what can go to the cloud, what shouldn't go to the cloud, what do you need to do internally with your systems to make all of that kind of work together? And then our overall mission and statement has been, we'll provide security in any form factor, anywhere you need it, whether that's on-premise, at the branch, at the home, in the cloud, whatever edge it might be or edge agnostic. We're platform-agnostic with regards to hardware, software and in the cloud. So I think that plays into what Keith is saying in the sense that you're looking -- companies are looking for ways to make that move, but also looking for ways to get more value, doing more of those things on 1 platform. We've been talking about our Security Fabric platform for, I don't know, 6 years now, 7 years maybe, even longer. I tried to go back to transcripts of several years ago and Xie had talked about in 2015 and 2016. At some point, your mail product, your SIM product, your sandbox product, whatever it might be that's in that platform is close to best-of-breed because we iterate and make it better every single year. And then we add additional things to it. So I think it all plays of that aspect.

Yes. I mean I think there's 2 different -- when I think about consolidation, there's several different segments. One is as you talked about is the networking and security, I think, is clearly vectoring towards consolidation and Fortinet candidly, is clearly winning in that area. I think Cisco drop the ball a little bit here personally. And then there's other points of presence, so to speak, within the security sphere that would include the things you talked about, e-mail, SIM, what have you, end point would be on that -- would be in addition to that. And I think those are still kind of the jump ball areas. And what's interesting is best-of-breed has typically one out, but the participants like Fortinet and maybe even Palo Alto, I think the burden of proof is you -- you prove best-of-breed, but once you're there and already established, it provides, frankly, some momentum on capturing incremental share associated with those areas. And -- but I think the burden of proof is still on. You have to prove that, in fact, you are best-of-breed or at least in contention for best-of-breed to get those incremental areas.

Well, Keith, look at what's happened to some of the best-of-breed companies, Proofpoint, FireEye, Forescout where are they today? They've all been acquired because they were best-of-breed in their category, Mail, sandbox, MAC, and now they're all gone.

Yes.

I think it's a very fair point, but I would add to that. I think that -- and Peter probably has his numbers, as to how many Gartner Magic Quadrant. So we are now with our Fabric offerings, I think it's 8, if we will.

We're in either -- we're a leader into -- we're niche or challenger in a couple of them were mentioned in others. It's a total of 8 Magic Quadrants that we're in or mentioned in with regards to the write-ups. And I'm going to let you take it from there, Keith. I know you can...

And I think maybe the other catalysts that's really started to emerge in 2021 has been the attacks are first like in current landscape. I think we all came into the year expecting that there'll be a high degree of conversation around supply chain has, in light of what happened with SolarWinds that we knew were expected companies would take some period of time to figure out whether or not they've actually been attacked and if so, what were they are going to do to get the bad guys out of the system. But I think things like ransomware and DDoS, ransomware, in particular, has really shown just the sheer volume of it. One of the two, it's become agnostic to company sizes. It's become agnostic to industry verticals. It's become agnostic to geographies. It doesn't -- we've got somebody here who has a friend of theirs, their small winery was attacked for ransomware for $10,000 right? And so all of a sudden, the customers that -- the best-of-breed conversation, particularly, I think, I understand the conversation. And when you have cash flow and security budgets, maybe in financial services or in government or in health care, what have you, I think that's a very compelling conversation to have. But as you've seen the net which has so wide over company sizes that now -- we certainly think I felt -- we felt in the second quarter and part of the first quarter continuing that. You saw our metric about other verticals coming online in a very big way for us. We think a large part of that is just a reflection of the current environment, unfortunately.

Going back to the 8 Magic Quadrant for a second. Our CMO did an analysis of competition, and he listed 100 companies that Fortinet competes against because we're in 8 different Magic Quadrants. Now, we're going to be the only one. I'm pretty -- I can almost guarantee this. We're going to be the only 1 that spans all 8 Magic Quadrants and that's products that are associated with all 8 of those. So we can compete with 100 different companies across different platforms. So we can provide all of those different capabilities and take market share from every one of those 100 companies and grow our business. That's consolidating the business.

Yes. I think there's more momentum about consolidation is my assertion. But let's stop there for a second and then go back to the firewall business. How do you guys think about the -- you obviously had a tremendous quarter in the June quarter, 40% kind of product growth. How do you think about the industry, not Fortinet, but the industry over the next 2 years, what do you think the industry growth will afford in the firewall business kind of growth rate?

Yes, I think it's going to -- I haven't seen the Gartner numbers recently, but I think historically or recently, people have talked about high single digits or something like that. I would certainly expect that it would be at least that. I don't know that you're going to see an equal allocation, if you will, that market share growth among the key competitors. I think that there's a couple of us I think that we're very capable of taking market share we have historically, and we expect that we're going to continue to in the firewall space going forward. So I think you're going to see the market share donors and the market share of donors, the market share of gainers as we go forward. There is -- I think there's a clear understanding now that firewalls are here to stay. And in fact, the use cases for firewalls continue as they have historically to just compound on themselves whether you're talking about SD-WAN security, for example, or SSL or segmentation, micro segmentation and DDoS of what have you. It seems that if you look back over time, people kind of have a vision of firewall sits in the data center. But the reality is firewalls sit throughout organizations and they're doing different things and solving different use cases. And I think that's going to continue to be a tailwind of the industry.

Yes, yes. And part of this is perhaps driven by COVID and the proliferation of ransomware, as you said, I think, providing additional level of scrutiny and budget relief, if you will. Peter, maybe I'll direct this to you. But how do you think about the growth of the virtual firewall segment within the overall firewall business?

Yes. I think it's part of the -- we would classify it as part of our cloud revenue of video streaming stuff. But yes, I think -- I mean, our non-firewall business is our non-FortiGate segment, over the last 3 years have grown 35% on a CAGR basis, right? Our cloud business over the last 3 years have grown 36% on a CAGR basis. So we think that will continue. We're certainly seeing growth in that business. You've seen it first 2 quarters of this year. I think we -- 40% product revenue growth of -- greater than 40% Non-Fabric or non-FortiGate product growth in the first 2 quarters of 2021. So I think that will continue. It goes back to -- we'll do the security wherever the customer wants it to be. If it's in the cloud that's fine. We think that's important edge. But again, we don't think it's the only -- we think it's much more of a hybrid cloud world that you need to be able to do both.

Right. What do you think you -- if you prognosticate your business 2 years from now, what do you think the mix is of fiscal versus virtual?

Well, I know that -- I mean, our CMO talks about virtual firewall as a service being nothing. I can't find it today. It's less than 1% of the industry. Yes. I mean I think right now, our non -- as Keith pointed out, our non-firewall business is about 30% of our billings growing at a faster rate than our overall -- our overall business or certainly than our FortiGate business, although that's growing in pretty robust rate all by itself. So yes, I think it will continue to grow as the size of our business. We said by the end of this year, our non-FortiGate business will be $1 billion business, and we're guiding to, I think, $3.25 million in revenue. So it's about 1/3. And I think that will continue to grow.

Why do you think the Firewall-as-a-Service? Palo obviously talks a lot about this, but why do you think Firewall-as-a-Service isn't a meaningful business in your eyes?

Yes. To be honest, I don't know in why. Keith, do have any view. All I know is my CMO is basically telling you that every customer he talks to, they don't talk about it at all. They have no interest in it at this point at all. And he said even back at our 2019 Analyst Day that the projections were that it wasn't going to be much of a business for as part of the team.

It is interesting that Palo obviously talks a lot about this, and you guys aren't necessarily seeing it as a driver of your business. Let's -- before we jump into some specific segments, though, I mean, your numbers speak for themselves, as I said, 40% kind of product growth versus 11 for Palo, which was a really good quarter for Palo, but still a pretty big gap in terms of your growth trajectory, and that's been -- Fortinet continues to outpace the industry by a meaningful amount. Maybe just jump down on what you're getting back from customers is the drivers of that incremental share, and we would anticipate that continues. But jump down in the level of kind of what you're hearing back from customers, what's driving that share?

I think it's probably a number of things, but one is the price and performance advantage. I mean I don't think that's a shocker to hear that we're viewed as providing a very high level of performance at a cost that perhaps is less than other people. I would attribute that back to the ASIC advantage and the most recently introducing the NP7 chip, which we're still in the process of going through. But I think I would also emphasize that in that performance concept when I mentioned the ASIC, people think about the ASIC enabling speed and capacity, and it certainly does do those things. But the capacity is what enables us to add more and more things to the operating system. When I talk about SD-WAN being added to it, SSL being added to encryption, de-encryption and what have you. There's a long history of things that Ken Xie and then Michael Xie have successfully stand-alone security features and functions historically that become embedded in the firewall. And that just -- that extends your price for performance advantage and it starts building you more and more towards that consolidation conversation that we had a moment ago. Other drivers in the quarter, again, we talked about the threat landscape and what we're seeing there. I think we came into this year feeling very good about the tailwinds that we had in those areas. We also thought that return to work would offer some tailwind. And I think it has. I mean, I think there were some projects that were probably on pause, if you will, last year. I think there were also displacement conversations incumbents that simply were not on the A list of priorities during 2020. And if CISOs and CIOs have come back to the office and they maybe sweat those assets maybe as long as they want to, I do believe that we're seeing more opportunities now to have conversations about displacing incumbents. The SD-WAN part of the business has done very well. I think OT performed -- we thought it would perform well in the quarter, but I would say it surprised -- that performed surprisingly well in the quarter. And maybe, again, as part of the threat landscape and what you're seeing in terms of reactions to things like colonial pipeline and what have you, and the proliferation of edges that Peter talked about. So I'd like to try and sound this down into 3 key drivers, but the list is will be a little longer than that. So I apologize for the windy response.

Yes. Let's...

I would add to that, our endpoint business did really long growth, right? So people ask us, which was the driver doing everything. Industries did really well with different sizes of SMB, mid-enterprise, enterprise all did very well. Different GEOs did very well. But I think one of the thing you have to add to that is our increased investment, right? We've been hiring a lot of people over the last couple of years. We certainly accelerated that last year during COVID, taking the T&E savings and reinvesting it into the company. We continue to hire. I think our headcount -- if you went back to last 3.5 years, I would say that our headcount has probably grown every quarter at about 17% on a year-over-year basis. So certainly that investment in sales and marketing, investment in the channel because we think the channel is extremely important to us. And then marketing, you mentioned at the top of this presentation. We're doing the Fortinet Championship event this year. We sponsoring a PGA tournament, for the first time in the company's history, and we're going to do that for the next, I think, 6 years, I think it is. We couldn't have done that 5 years ago. We just weren't a big enough company. We're just for well enough known. And it's definitely driving -- we're going to have several hundred people coming down to Napa, channel partners and customers and a few analysts and some investors as well. But really being able to do that and having that marketing capability, even inviting people who aren't customers and then they're saying, well, sorry, we can't come this year, but we'd love to talk to you about your product. And so it turns into a sales opportunity. We're definitely seeing.

Right. Can you talk about how should investors be thinking about new customer adds up pretty sharply this last quarter, tremendous growth, actually. How should we be thinking about new customer adds past this quarter over the next number of quarters? And is there any -- what's the commonality of the new land?

Yes. Great question. And I think that we haven't given a specific number, I think, consistently. But I think that we have kind of shared with people that we have a 5,000 -- we add 5,000 new levels in the quarter, it's a pretty good quarter for us. And we did specifically call it out on the [indiscernible] call to say that growth in the second quarter was 50%, I believe, in terms of new logos. As you would expect with our mix of business, it's 1/3 SMB, 1/3 mid, 1/3 enterprise. The new logos you're going to get up 1/3 of number of logos, you're going to get more of those from the smaller companies as you -- and maybe a little bit less on the enterprise. That said, still very, very pleased with the enterprise growth that we had in the quarter, which I believe the G2000 growth was high 20% for us in the quarter. But the new logos tend to not add a lot of revenue in the quarter, which we signed them. It's the typical land and expand type of approach, very low double digits in terms of percentage contribution. But it really does, it positions us well as we go forward. Obviously, we tell that customer, typically the first firewall. That customer will then [indiscernible] and we'll find with them additional use cases for the firewalls inside their organizations, but also then the non-FortiGate, the Fabric product it's a very nice expansion point.

Yes. Yes. 50% is just such a strong number that it kind of jumped off the page when you guys said it on the earnings call?

Yes. And I think, again, it would kind of speak to what we saw in the second quarter. We talked about before, and just although these companies were reacting to a lot of catalysts, whether they had money, whether it was the attack surface, whether deals are on pause or what have you. But again, when we look at the pipeline in the third quarter and for the rest of the year, I don't see that those catalysts are going away, and I think we feel very good that that's going to continue to be right tailwinds.

Yes. Yes. Okay. Before we get into the non-FortiGate, I have few other questions I want to stay on the FortiGate, but maybe talk about your partnerships with the hyperscalers and how you think that's both adding value, adding opportunities and any kind of risk that you would point out with the hyperscalers. But talk about a little bit about your business and partnerships with the hyperscalers? And then I want to jump to 5G after that as well.

I'll jump in, in hyperscalers and save 5G for Peter and [indiscernible] hyperscalers. I think the hyperscalers remain a significant opportunity for us, particularly with the NP7 chip that -- we rolled that out as we would expect in the high-end products first. If you look at total shipments, I think we gave this number. There were 10 products that now have the NP7 chip and our high end and they represented about 25% of our business. We expect that obviously is going to continue to increase, and we'll eventually get to very, very close to 100%. And as part of that, I think the hyperscalers just because of the performance of the NP7 chip is something that I think we can come back and have renewed conversation with them.

Just to clarify, the 25% was 25% of high-end units for NP7 on our entire business.

Understood. Peter, maybe talk a little bit about 5G record. I remember asking some of these questions last year about 5G. But talk a little bit about what the opportunity is for -- opportunity set. And also why Fortinet is -- this is a better opportunity you think for Fortinet in particular, versus some of your competitors on the various businesses.

Yes, we've been building 5G capabilities into our operating system over the last couple of years in anticipation of being not -- being a growth driver. Similarly, what we did to SD-WAN, I guess, in the sense that you build it in, you prepare for that opportunity when it comes. I know Ken's been talking about 5G being a growth driver this year. If you look at our OT opportunities that Keith mentioned earlier that OT very well in the second quarter, I haven't gotten to see if those are directly related to 5G, but I would guess that some of them are. Because one of the big 5G opportunities is operational technology, where companies are basically creating their own hyperscaler scenario, where they're running their manufacturing floors. I had a conversation with our European sales force people. I think it was in 2019. They were talking about how 5G was going to allow these companies that wanted to do it to run their own cloud and run their manufacturing floors off these hyperscalers situations. And then what they would -- I would have thought they would have been concerned about speed and the amount of data they were pushing through and my sales people said, now the biggest concern they have is not knowing what's all connected to their network because they can connect so much under a 5G scenario. So really being aware and then -- and you can't protect what you're not aware of. So being aware of everything that's connected to the network and then being able to protect that. So it's not an entry point factor. So I think -- and again, this kind of goes back to the 2019 conversations I was having. We were seeing SD-WAN RAM at that time. We're continuing to see it do very, very well. The projections back in 2019 kind of took us into 2022. The projections go a little further and say it's going to continue to be a 30% to 40% industry grower on a going-forward basis. But even if it were to plateau in 2022, I figured 5G was going to start to ramp at that point. So I think you'll see more of it. We're benefiting probably from a little bit this year in the OT world, but I think it will continue to benefit and have that capability built into our operating system. Again, back to Keith's point, we can build that in and run it on our ASICs because we have that throughput capability or that power and the machine and then start benefiting more -- even more from it.

Right, right. And maybe just continue on that thought process. But how do you see SD-WAN growth? And then put another line on how you see 5G? In other words, does the proliferation of 5G, I don't know, 2, 3 years from now, in any way, shape or influence the growth of SD-WAN longer term?