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

Very lucky to have with us today Ken Xie, Chief Executive Officer of Fortinet as well as Peter Salkowski, Head of Investor Relations. Just to frame out the session a little bit, we've got about 30 minutes together maybe what we could do is I'll take the first 20 minutes to run through some fireside chat with Ken and Pete and then I'd love to make this interactive. Any questions that you've got just feel free to shoot me an e-mail at [email protected] and I'll make sure to try too weave in as many as we can in the time that we've got. So maybe 2 things. First and foremost, Ken, Peter, thank you so much for being with us here today. And then secondly, Peter, I'm going to kick it over to you just to get us started here from a regulatory perspective.

Just real quickly share my screen here. I just want to make everybody aware of our safe harbor statement, which you can all read very quickly, those speed readers go for it. Quick statement. 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, risk factors in our most recent 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 those 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. With that, Saket, back to you, and we will go from there.

Excellent. Great. Thank you, Peter. Ken, again, thank you so much for being with us here today. Ken, there were so many good things to talk about from last quarter's call. Can you just maybe talk about the points that you were most proud of as a CEO? And Pete, maybe just -- maybe you could fill in some of the financial detail in there as well just to help us all level set, if that makes sense.

Yes. Last quarter, we have a very strong growth. So you can see the product revenue grew 51%, building 42% is all pretty strong, probably stronger in the last few years. It's driven by like a few factors. So we do see -- it's kind of a [ region ] from very beginning, which is 21 years ago, we could secure-driven networking, converting our network security together is starting happen. So the traditional border security, which a lot of network economy deploy product [indiscernible] still there, still grow like 10% in the last 20 to 30 years, but security also expand internal to the internal segmentation, the [indiscernible] ransomware, they go to the one side, like a secure SD-WAN, secure 5G. So we see very, very strong growth driver there. Also, we see that kind of drive the FortiGate growth, the same as non-FortiGate growth both like above 50%. That's the first time FortiGate starting catch up compared to the non-FortiGate. It's been the inter growth ceding the last 2, 3 years, which almost doubled FortiGate growth. So the FortiGate other growth driver we call the fabric approach or the government called the MASH Security [ rector ], which is really about enterprise consolidated different vendors into a single platform. So the network can work with endpoint, work with where the e-mail, all this cloud, all this defend solution integrated automate approach. So which we also see is a pretty strong growth driver going in the past and also going forward. And also definitely the secure -- the landscape there, you can see the rents were like raised almost 11x compared to 1 year ago, a lot of security issue try to support it from work for homes and other parties also one of the growth driver. Probably Pete has some other standard comment.

Yes. I think from a numbers perspective, Saket, that you're talking about. Now if you look at it, I think one of the themes that have been playing out very well for Fortinet over the last couple of years is really the diversified business. We're very diversified by industry verticals. We're diversified by customer segments. We're diversified by geo. If you look at it by industry verticals, for example, one of the things we pointed out in the -- it's actually been the last 2 quarters is we've always, historically, if you go back and look at our transcripts over the last several years, we talk about our top 5 verticals, right, service provider, governments, financial services and a couple of others. But if you really look at the non-top 5 verticals, the last 2 quarters, they've seen really strong growth. And I think that's due to a lot of different factors. But this last quarter, for example, they used to be 1/3 of our business in terms of billings. In this last quarter, they were 40% of billings, and they grew 68% on a year-over-year basis, which just talks about the different verticals and how diversified we are. The other one to look at is customer segments or customer sizes. If you look at our Global 2000, for example, the billings in the Global 2000 were up over 50%. So again, very strong growth in different customer size businesses. Then if you look at it from a geo perspective, all of our geos did very, very well. There was a strong growth in Americas, there was strong growth in Europe. There was strong growth in Asia Pac. So across all those different sort of ways to slice the business, we just saw really strong growth. And so there was nothing to point out that it was a weakness. It was just sort of which ones can we point out that are stronger than the other, which is a good thing to have, certainly.

Good problem to have, absolutely.

Yes, exactly.

Well, for sure ...

Margins that are above 25% non-GAAP operating margins that were north of 25%, which has been a target of ours for several years.

Yes. And maybe just to double down on that point, right? I mean certainly well above a rule of 40%, which has also been a hallmark of the model here for some time. So totally understood. Ken, maybe back to you. You've been in this industry for decades, and I know you spend a lot of time with customers. What are they telling you about the willingness spend on firewall and also about their willingness to consolidate security spending with platforms like Fortinet.

Yes, that's where like we did our own survey but also if you look at [ Ghana ] survey, let's say 80% enterprise is doing in the process doing to consolidate lot of a different vendor for their whole security infrastructure. That's actually met our vision quite well, which we do feel like that's our FortiGate Fabric approach, which is -- we do see pretty strong growth and also consolidate, integrate, automate altogether, which not only helping customers save the cost, the management costs, but also make security more secured by automated response with all this [ Analytics ] tool with all the AI, with all this Machine Learning, all this Big data approach. On the other side, they definitely expand the big infrastructure now, which also see is a huge kind of opportunity. And also like work from home and all this kind of -- It's also kind of opened up a lot of new tech service, also a lot of need to be protected. So that's where we see very strong demand right now.

Got it, got it...

It's important to point out, I think this is not an overnight decision that Fortinet's made. We've been building ASICs or designing ASICs for 20 years. And so having the ASICs and having that capability, allowing us to add a lot of functionality of the operating system. But even Ken pointed out that the security fabric or Gartner's view on what they call -- they actually call it their cybersecurity mesh architecture, CSMA for their acronym. And we've been building that platform for over 10 years. So I think we're getting to a point now of maturity on a lot of the different products that are in there and continuing to add additional functionality and will continue to do so and can do so because of our ASICs. But I think we're getting to a point of sort of critical mass on maturity for some of those products, where vendor consolidation is actually a reality for customers now, partly because of our ASICs, but also because of our operating system.

Yes, absolutely. I definitely want to dig into that a little bit more as we go on. Ken, I maybe love to dig into the FortiGate part of the business for you a little bit. And you touched on this a little bit more, but I wonder if you could expand -- you've talked about more use cases for firewall in the past. Which do you think -- Can you talk about which are the more newer use cases that you're seeing? And which ones are sort of growing the fastest? And why?

I think in the last few quarters or the last 2, 3 years, we keep mentioning SD-WAN helping drive a lot of our FortiGate growth. Basically, half of our SD-WAN customers, new customers, newer using Fortinet product before. So that's where it's kind of a vision to -- we call secure-driven networking as a converged traditional networking into the security, network security, which can see the content, can -- based on application or use or device throughout the traffic instead of just kind of everything together in the same price level. So we see that nothing starting taking off, not just SD-WAN, but also 5G. The other area, we also the first time disclosed last quarter is the OT. So you can see SD-WAN OT together is over 20% of our total business right now. And OT last quarter grew like 77% is over 6% of the company business right now. So we do see OT eventually will be bigger in the next year when also can grow faster there because like Peter mentioned, there's a lot of new attack service, especially when the 5G connects a lot of devices together. So all these OT area, IoT area need to be secured, it's a huge opportunity for us. And therefore, we also see how to secure the cloud, how to secure within the data center within a compass to protect all the research is also pretty big. So with a new ASIC MP7, which the single chip can process 200 gig traffic, which really helping to start and deploy this kind of network security in the high-speed internal network environment, which is almost impossible in the past to costly to difficult to manage. So we see a lot of opportunity to open up and it's long term, I do believe this space -- So the network security space will gradually take over the traditional network space, we call secure-driven networking to the conversions going on right now.

It's really interesting ...

Ken mentioned SD-WAN as a growth driver for the firewalls and totally agree with that statement. I think the other thing that we've looked at the last couple of quarters is how much of the growth in the FortiGate business is coming from SD-WAN versus just other use cases that we don't specifically track necessarily because it's not as easy to track as SD-WAN is. And what we found in the last couple of quarters, more of the growth in the FortiGate business is coming from all the other use cases that firewalls can do. And Ken mentioned that the micro segmentation sort of capability or the different use cases for the firewalls that we have, whether it's micro segmentation, zero-trust, SSL inspection, for example. To give the -- I heard my Chief Marketing Officer, say yesterday, our 7000 Series machine that's got multiple NP7 chips in it that are our latest chip, that machine can do 300 gig of throughput of SSL inspection, right? There's nobody who can match that in the industry. So that's a big differentiation for Fortinet and driving growth in our business.

Yes, absolutely. Lots of different use cases there, really interesting. Peter, maybe for you, while we stay on the topic of FortiGate, supply chain is obviously the buzzword, not just for the firewall industry, but a lot of my other companies as well. Can you just remind us how Fortinet sources and manufactures most of its appliances. And to the extent that you are or Ken want to comment, what's your gut feel on kind of how long this disruption -- how long it will take for this disruption to start to abate?

Ken, do you want to start?

No, go ahead.

Okay. We can take [indiscernible] as well. I mean, I think what we said in the last couple of earnings calls is, look, we have some advantages relative to our supply chain and the fact that we hold a lot of inventory. Our inventory turns have been between 2x and 3x over the last multiple quarters, which would recommend or suggest that we have 4 to 6 months of inventory at any given time within our own inventory. Our channel partners hold inventory as well, to some extent, although we limit what they can hold. So we've been able to mitigate some of the risks that's been involved with the supply chain. You don't put up a 51% product revenue growth number without having product to ship. So we certainly have been able to mitigate that. Some of the reasons for that is, one, we hold our own inventory; two, we manage our supply chain internally through our own operations group. So we have a team of people who are out there every single day trying to source different products from different vendors. We use a multiple -- we use a lot of different contract manufacturers for different supplies, so we can try to work around them in terms of getting supply from one or the other in any way we can. We have a very large SKU list, so we can move things around a little bit. If something short in one place, we may be able to sell them a different firewall, for example, because we've got a different firewall capability that we can use that we'd have availability for. So there's a lot of different ways around that. We did have backlog at the end of the third quarter. We did say on the third quarter earnings call that there was some backlog that most of it was in the networking equipment side of it. We expect backlog to be greater in the fourth quarter, partly because it's a seasonally strong quarter for us, probably some more networking capabilities will be in there. We did see it probably isn't going to flow a little bit into the firewalls as well just because it's a supply-constrained situation. Certainly, a lot of that demand constrained situation. But that's all factored into our guidance for the quarter. What we think our backlog is going to be as has already been in there. It's not in the billings number because it's not something we're going to ship. So I think that -- that and the fact that we ship a lot of units. If you look at the latest IDC data, which I think is second quarter data, we ship 38% of all firewalls in the industry were Fortinet firerooms. So it's multiple times more -- go on.

Yes, Peter, definitely well covered. The few others since it's already I feel the supply chain issue probably will be bottom this quarter, next quarter was start recovering. So probably Q2 or mid next year. And same like Peter mentioned, because we have to quantity probably like 3x more than the next competitor and like 12, 15x more than other like Palo Alto Network. The quantity can give us a better negotiation power with whether the component supplier to manufacture which we also have our own manufacturing team, we have our own operations team and our own warehouses we kind of more manage it directly compared to some other competitors using the third party just in time, which can save some cost, but definitely has more risk on the inventory side on the manufacturing operations side. So that's who for us. We're kind of more looking at this for long term and just treat as long-term investment just like ASIC. So we feel invest in the supply chain manufacturers and other part is also very important for company healthy growth. So we kind of have a better position than most competitors right now.

That makes a ton of sense. Ken, maybe just to double-click on one of the topics you brought up earlier, which is SD-WAN. It's a fun saying, but I mean, Fortinet's pricing strategy is here to be. It was tough to beat, right, with sort of free with SD-WAN. But I guess the question is, customers have the option of having a dedicated SD-WAN appliance or maybe even a cloud service. Why do you think that customers want to combine SD-WAN with a firewall. And for those that don't want to combine them for those that do go with other options, what's the reasoning for not combining them?

So even competing just for the SD-WAN function [ links ] in FortiGate still cheaper has a better performance because the huge combining power advantage come from for the Forti ASIC chip. So that's the beauty, that's the benefit of using FortiGate. And in the past, you have more function. So like I said, when you kind of do this secure SD-WAN -- It is the first protocol, they can deliver or different traffic based on different applications. But combined with security anomaly and result-based application, you can also based on the content, based on the device, based on the user, anything secure you can see, you can make a decision on the networking side. So that's a huge benefit for the customer. And at the same time, there's a lot of other functions able Basically, if you look and work for a home as a branch office, we can use in 1 box to replacing 3 box, replacing the traditional networking box, you place the SD-WAN box, you placing the security box. So that's only a single box solution were easy to manage wherever high performance and the low cost. So that's the benefit we see also strong we're working with pretty much all the -- like a carrier service provider and also other big enterprise like we announced with AT&T, Verizon, Comcast, BT, Orange, all this kind of working together with us, try to supporting different sizes of enterprise, we work for home, how can use [indiscernible] to lower their kind of -- like a [ WAN ] cost. I think so far, we see very strong. I think we are probably the leader and #1 media in the space, none #1 will be very close and also [ chipping ] growth probably the faster growth in the whole industry.

Yes, absolutely. Peter, maybe since we brought up pricing, I think this was talked about a little bit in the last call, but just to make sure we're on the same page. Can you just remind us of some of the pricing changes that Fortinet has made recently? And again, just to sort of put a bow on that topic, how should we be thinking about that in terms of impact in Q3 and going forward?

Yes. So we've done 2 price increases, 1 of which effective August 1. Of course, we have to announce that 30 to 60 days ahead of time. So it was effective August 1, when we announced I think on July 1. And then we had another pricing increase. That was 7% by the way, across the board. We had another price increase on November 1. That one was a little different. We had a little more time to kind of evaluate what prices to raise and where. But on average, I would say that was probably about 5% across the board price increase. On product, but that affects services because services get attached to product. So it really is across the entire entity. I'd say from an effective perspective, there is some buying that occurs ahead of the price increase. You notify them on July 1. They start buying in the month of July to kind of get ahead of the price increase, we do control [indiscernible]. And that's mostly channel, not customer that would be buying in that scenario, but we do regulate how much they would buy in that case. And then you do have existing sort of bids that are already out there that may close in August through September but you would be promising the prior quotes in terms of prices. So we certainly didn't get all of the 7% in the third quarter from that price increase. Plus, you also have to take into account discounting, there's sort of a 40% discount immediately off the top to the channel. So we don't think we got much of that price increase in the third quarter, maybe 1% or so of impact actually in the quarter. Similarly, this price increase that would have gone in effect in November 1, but go through the same cadence you're going to get buying in October, which is in quarter, but you're still going to get a little bit of pull forward into October that will normalize in November and then you'll start getting more of it in December. So again, 5% -- maybe we get half if we're lucky in terms of that. Now in 2022, we should get a bigger percentage of that. But keep in mind, you're still going to have the channel discount. So maybe we get half of those next year after everything is all said and done. As long as our quotas are increased for our salespeople, right, to offset that, so they don't discount it all away, it's all part of the management to.

Yes, absolutely. That's really helpful detail. Ken, I maybe want to switch gears a little bit and talk about SaaS a little bit, right? One of the questions that I get every once in a while from investors is whether branch firewalls, which isn't the biggest part of the business here, but is a decent part of the business. Whether branch firewalls will see more competition from SASE offerings, right, like the Zscaler and [indiscernible], for example. Can you just talk about, Ken, just how much of a risk do you think that is? What do you sort of see out there, maybe just to start.

Actually, we see the SASE approach a little bit differently. And also Gartner also changing their SASE definition right now, like in passive [ SASE ] all kind of cloud delivered. Now the channel has to be local delivered. Some is the local some cloud. So that's for us, we believe SASE will be better, like the branch office, all this handled by local like [ NH ]. That's also the reason we announced the FortiOS 7.0 in March this year, early this year, and integrate all the SASE function into the same OS in the SIM appliance, which also we're working well with service provider like pretty much all the major service provider working with us to offer their SASE service based on their infrastructure. And you can see -- that's kind of a different strategy than some other SASE providers like Zscaler, which as based on their own top or on the cloud. So that's what we feel. If you process a lot of our data traffic locally will be much faster, more efficient. And at the same time, kind of like easy to manage. And that's the mission we have. And so far, we found most of the service providers also supporting this partner, even Gartner changing their view of how SASE should be delivered, should be managed. And yes, we see pretty strong interest in our own SASE solution, which is take a long time to build. We have to integrate all these things together, not just SD-WAN, we already have but also CASB firewall service or the other since there -- in the same OS in the same appliance at the same time, how to manage, cognate all these different traffic together within the service provider, with this kind of different infrastructure globally. So that's what we see pretty interesting kind of partnership forming right now with all the carrier service provider and offer SASE to support a lot of enterprise work for home and the branch office.

That's really interesting, actually, just on that go-to-market because there's so much of a service provider business here as well. So that will be interesting to see unfold. Peter, maybe for you, just to also ask you a little bit of a product question, just maybe a space question. How does Fortinet sort of define SASE? And as part of that question, maybe we could compare it to others, how others in the market talk about, SASE, particularly the ones that have maybe started more so as secure web gateways. Does that make sense?

I know what you're talking about. But yes, I mean, to Ken's point, I mean, this is a recent change by Gartner. They're talking more about -- there are on-premise capabilities relative to SASE, for example, SD-WAN, right? You need to deliver the traffic to the cloud to be able even to do the cloud capabilities, whether it's CASB or firewall as a service or secure gateway, which you just mentioned. And so there are certain on-premise capabilities that they say are going to be in existence for a long time, which is what we believe in a hybrid cloud world, that you're going to do some things as part of that SASE model, on-prem, and you're going to do some of those things in the cloud. Our view is that it doesn't make any sense to send things to the cloud that are happening on-premise. So really, for example, OT, right, we talked about it a little earlier in terms of seeing really strong growth in OT. If you're doing an OT security situation, you have operational technology. You have a manufacturing floor that's being run and you're trying to secure that data that's being created at that location, it makes no sense to take that physical location, shoot the data to the cloud is secure and then shoot it back down to the floor to protect it. You should protect it exactly where it is. And so we have products that will work in an OT environment to allow that to happen. So I think that's part of the thinking there. There are certain things that work in the cloud, and therefore, you should be able to secure them in the cloud. And so that really comes back to the operating system and the holistic approach of being able to do things on-premise as well as in the cloud. The difference in philosophy, I think, from us and some of our competition is we don't feel it's a profitable business to build out 150 different POPs around the world and try to manage all of that cost as well as just manage all those data centers that we would prefer to partner with our service provider friends to provide that -- leverage their existing infrastructure, provide them the security capabilities with our operating system and our appliances and allow them to act as the service provider, which is what some of the current secure web gateway companies are doing.

Got it. Got it. That's really helpful. Sorry, Ken, you were saying something?

No, I'm good.

Okay. Got it. Ken, maybe I'll ask you a strategic finance question now as well. I mean some of your competitors have talked about more attached subscriptions . Does Fortinet have an opportunity with something like this? And if so, what areas do you think could be interesting from, again, an attached subscription to the firewall.

The FortiGate because this ASIC capability, they have a much more computing power to add more function there, like -- Now we offer a lot of functions for free, like SD-WAN example. Our competitor like Palo Alto for 20% of semis service, which we believe may be long term with customers some more needs for supported, we can charge that. But also you can see FortiGate today has almost 20 functions though. And a lot of them, we can add additional service. That's all how the product revenue growth eventually can help in driving the service revenue growth going forward. And that's the one we were keeping improving with the new ASIC, we'll keep adding additional computing in power and also we're keeping improving the [ FortiOS ] more function there. So that's where we do see long term. It's a healthy model. That's also we want to keep in risk margin, whether for our customer or partner ourself. And eventually, it will benefit the whole industry.

[indiscernible] SASE question just for a second. I look right now, a lot of SASE revenue is SD-WAN and Zero-Trust, right. It's not all -- there are 13 different components to the SASE statement that Gartner made a couple of years ago that defines SASE. But really, if you look at it -- and then I guess the [indiscernible] Gateway, which is what the Zscaler is doing, right? So it's really limited of those -- it's not all 13 products that are generating a lot of that revenue. SD-WAN, which we believe is a market that's really important. You can't deliver the data anywhere if you don't have that capability at that location. So that's going to be really important. And then Zero-Trust becomes a big part of that. It really goes back to Ken's philosophy of the security-driven networking them, right? The ability to move security and networking together and being able to handle those 2 markets within our appliances or within our operating system to do anything that's going to be related to security and certainly the SASE [indiscernible] . On your question on subscriptions, given we do have subscriptions. We have FortiCare and FortiGuard, 2/3 of our revenue is subscription based, right? So there is a, what I would call, a hybrid SASE model in our income statement that those services are coming off the balance sheet revenue that the services revenue coming off the balance sheet. So we do have services there.

Yes. We also have a search service we call [ FuliTrust ] announced last quarter. It's more like based on the user base, new trust kind of based, so you can cover multiple device and go through the whole infrastructure to support our work from home or all this kind of work from anywhere.

Really interesting. Always fun to see the innovation at Fortinet. Well, folks, it's -- as I'm telling a lot of my management teams, 30 minutes goes awfully quick. And I've got so many more questions to continue learning about the business, but also want to be respectful of everyone's time. Ken, Peter, thank you so much for the time today. I really appreciate it, and great to see all the good things happening at Fortinet.

Yes, great to discuss me together.

Yes, same here. All right, thanks folks. Enjoy the rest of your day.

Thank you.

Thank you.