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

Thank you very much for staying with us for a discussion of Fortinet. We hosted today a session about cloud security, and then we hosted Nikesh from Palo Alto. And now we're talking about Fortinet, one of the most successful companies in the space. That even I have to say, you didn't hear the presentation, but even your competitor Nikesh acknowledged you and him as the most successful security company. So it's not me saying, it's you're a competitor.

Yes. It's obviously Nikesh.

Yes. But I'm pleased to host Ken Xie, Founder and Chairman and CEO of Fortinet; and Keith Jensen, the CFO, and we have in the audience, Peter, do we have any questions that these gentlemen cannot answer, of course. And I normally start with a -- the technology discussion. This time, I want to start with Keith because yesterday, we had dinner, drinks with a few friends, and someone said, he said, Keith turned into the best CFO in the industry. And to hear it from a leader in the hedge fund industry, it's great. And I want to ask you about -- talk about the challenges of running the financials of a company like Fortinet. Talk about your focus, what are you focusing on? What are the things that are top of mind for you? And how did you turn this challenge into a success story.

I didn't expect that question.

I know it's not on the list.

I think Fortinet -- If you're going to be a CFO, become a CFO of a company that has superior products in a market that's growing like crazy, then it's very, very forgiving. Philosophically, I think that data, I just spent a ton of time mining data, looking at data, looking for trends and so forth. I think as I developed the team or the team develops me, I think that's a very common aspect. It's also a way that I think that can consumes the times with very much a data focus. So I think if I have to pick a word off the cuff, if you will, I think that's really kind of the key to it.

Got it. What are you focusing on? What are you -- how do you spend your time when you think about the financials, you have to manage high growth. You have to manage supply chain. You have to manage margins, you have to manage cash flow. What are you focusing on when you think about reporting when you think about consistency and visibility.

I think the -- managing the growth and the challenges that have come, if you will, over the last couple of years. I think the one thing that I've seen with my peers and my team is that and it sounds very vague, it's only to place a premium on problem-solving skills because you don't know what we see in the last 2 years, it's a different problem every quarter, every other quarter. And there isn't a road map for solving each of those problems, whether it was supply chain issues originally in COVID coming out of Asia. And you could -- there's no room in the belly of plains to ship things, if you will, to variants that we have the waves of COVID to now a chip crisis and then kind of a war in between. I don't think there's a playbook for anybody. So it really comes down to having people that you've surrounded by that can solve new and unique problems.

Got it. Ken, you reported Q1 revenue -- product revenue growth of 54%. Service revenue growth of 24% as well as billing growth of 36%. These are just amazing numbers. What drives in the core of it? What drives this high growth? And how sustainable -- what do you do, not how sustainable? What do you do on your end to make sure that this growth is sustainable?

Okay. Yes. First of all, I believe is you is definitely the best [Indiscernible]. Peter also, I believe is the best. Yes. So since a few years ago, they started needing a function we could see company start keeping growing well. Also back to your question. So you can see last quarter, Q1, the booking of product is over 80% growth. So we have never seen such a strong demand for like security, network security plant over 30 years as industry 3 different company because we do see the threat. We talk about 3 drivers, the threat environment, like all the reservoir issue some other both homes, the more like a tech surface and then the convergence of network security and also the platform approach. How these 3 drivers drive the growth. And so even we deliver building growth on product building growth 54%, you kind of add additional backlog there. So I do see the 3 drivers then drive the growth going forward. I don't see anything kind of a change in the driver also. Security also is a very fragmented base. I don't see any competitor in the other as more than 100% of the market share for both. As [Indiscernible] fragmented and [Indiscernible] fast changing space -- so we do have some kind of long-term investment by some kind of advantage like ASIC chip, like all the internal development of products in the platform like some product -- it can help us keep it growing and it's the best time in the industry.

Got it. I know Peter wants to meet to highlight this, maybe. Peter, I'm on your end -- on your side.

This is the key to being a great CFO is to know it is a safe harbor statement and refer people to it. Perfect.

So we got discovered. And Ken, I want to basically understand the components of your success in a sense that when I look at -- there are a few players in this space. We have Check Point who in their best days growing 7%. We have Cisco that accelerated from 1% to 7% growth in their security. But then we have Fortinet with completely different numbers. It's an order of magnitude higher. What do you think is making you so successful, much more successful than your key competitors, what are the components of it? Is it about the product? What about the channels? Can you talk about the channels? Can you talk about go-to-market, people in the organization, et cetera.

We have a little bit different strategy compared to some of our competitors. We do see the importance of some long-term investment, both on the technology product side and also in the business model side. On the technology product side, like whether the ASIC or internal -- more focus on internal developed product in that acquisition, and we feel give us a better long-term return. And also, on the business model, we also want to keep in a healthy margin and then grow as fast as we can under the health margin, which we mean GAAP margin. So that's where I see there's so many players. You can see the ASIC this week. There's so many companies in this space, but I have to say most of them really is important solution or kind of a little bit short term, getting some space. I have to say certain approach is a little bit short-term focused. They can benefit in the short term, but difficult to go long-term growth. So that's what I see. On the other side, also, there's so many cloud companies even like early this morning for cloud security. I do see it's kind of interesting cloud being one network secure. So whenever you try to apply more cloud security, there's more strong demand of network security applied access [indiscernible] and also, we see [indiscernible] strong growth on the home security side. But that's the 2 things we mentioned separate revenues, but the SD-WAN growth is about 15% of the total last quarter and grow like 54% year-over-year. And then the OT security grew like about 10%, which grow like about 80% and [Indiscernible] strong. And also we see the importance of network security and OT cybersecurity space because different than the traditional like security or laptop or mobile phone, you can buy an endpoint software into the laptop or mobile phone. In OT space, most of it, most whatever device there, whether they have a totally different OS or the device itself don't have enough company security [indiscernible] functioning, the only solution there were they using network secure connection, which 5G a lot at OT connection, [indiscernible] IoT connection compared to [indiscernible] people. That's we do see [ Barberton ].

Got it. When I do -- I talk to the channel from time to time, and I talk to distributors and VARs and solution providers, and they always highlight Fortinet. They love reselling or they love integrating Fortinet. What do you do with your channel strategy that makes them so happy? What are the big components? Because everyone understands that they need to be nice to the channels. But when I talk to them, they certainly prepare you over other. So the question is what do you do with your channel strategy that makes your channel partners so happy.

Yes. First, we are 100% coming into the channel, which a little bit different than some of our other competitors whether some of them will go directly to the customer or whatever the model to try to take some service from us. Second, also, we feel a strong product like whether in the hardware side using [indiscernible] computing region. For the same function, for the same cost, on average, we have 5 of them available. And also on the service side, we probably charge on average about half of the service or competitor because some of service, the SD-WAN service, some SD service we offer for free. Some other service, we sold like a bundle of 80% service bundle, which has both these -- some other services, even individual service, we take less percentage like 20% as part of our competitor, [ 25% to 30% ] . So that's why even on the button the OS set, we offer more function and offer more service, but services are about up and then the border also tend to be 5 to 10x better performance. So there's a lot of room for the service provider, for the channel to add their value for supporting the customer and also profit model. So that's where also kind of what we kind of commit to the channel. That's also the model we have different smart competitive probably more target some big enterprise first. But for us, and also we were very successful in international. It's really -- because international channel tend to do more marketing, more supporting themselves, whether they're a local language or whatever way [indiscernible], so that's where from our beginning, we are very engaged in the channel, which we did over long-term relation the last 2022 close to but be good [indiscernible].

Got it. Maybe a question for both of you. In the recent Analyst Day, you disclosed your 2025 targets. These are giant targets, $8 billion in revenues, $10 billion in billings, what are the components of this growth? Where do you think is the highest opportunity for you going forward?

Yes, I think that's the -- as we look forward, I think we're very excited about the situation we find ourselves in, which is we think we have a superior product offering based on what Gartner has to say, another third-party has to say. And as Ken pointed out, it's an extremely fragmented market. It's difficult to find somebody to cross this $200 billion of TAM that we're looking at in 3 or 4 years. It has more than 3 or 4 points of market. So you have the situation where you have a tremendous product offering, you have a very fragmented market. It's really an opportunity to continue to invest in your go-to-market strategy whether it's through the channel or whether that's through your own direct sales force working together. It's actually very logical to continue to invest in the go-to-market strategy, keeping the capacity growth in check with the pipeline growth. Those are the 2 key metrics we look at as we go forward. And then below that, if you start pulling back the onion and you look at the continued success in areas like SD-WAN and our objective to be #1 in the market there. And OT, which as Ken's talked about, is approaching 10% of the revenue, the platform extension that has now passed over $1 billion in revenue. We think it holds together very, very well. And we think that the way that we've run the business for the last several years, is a clear indicator of what we should expect to see as we continue to go forward.

Got it. Maybe I'll drill down last quarter, your core products, core platform. The product revenue grew 50%. That's the FortiGate grew 50%. Why is Fortinet succeeding to grow so fast in "legacy areas" in areas that your -- some key competitors cannot grow. I ask this question more in general. Now I want to focus maybe on the quarter 4 FortiGate solution.

I think the 2, 3 factor, one is really the long-term investment we made in ASIC give us a product advantage on the performance side can add more function there. And on the other side, also the market driven there, so it's an expanded market, beyond the traditional firewall security there. Really work from anywhere from home, from whenever, remote space and also expanding to the internal, like internal segmentation and protect this ransomware attack. Also the SD-WAN, 5G, so it's quite expanded here in the new trust network environment there also drive a huge demand in the space there. And so we do see -- it's really helping track. But also the service revenue, we do believe we actually follow up after the product. I think the product revenue side will probably already become the biggest company in the industry, and then the service, additional service -- so we also mentioned probably the server to go back to 30% in the second half.

Got it.

And I would add to that, I think the diversification of the business model that -- if you look at ransomware, which has been talked about so frequently in the press over the last year or so and how agnostic it is in terms of what industries it will attack, what geographies it will attack or what I should say they, the bad actors and attackers, that the verticals, the size of the customer, the location of the customer, it really moves very nicely in tandem with Fortinet's diversification of the business. and a firewall offering that covers all sizes from the large data center to things that actually can cure data on the floor. I think that catalyst, if you will, you saw that come through very, very clearly over the last year or so. And we would expect that, that's going to continue, to be honest with you.

Part of FortiGate is the SD-WAN market. And SD-WAN grew very nicely. You gave some numbers in the last quarter -- in terms of bookings, it grew 54%, and it represents, I think you said 15% of billings. So what drives it? And how is it synergistic to your business? Can you talk about basically the SD-WAN opportunity and the future of SD-WAN.

First, we offer the SD-WAN function part of OS function for free. We also don't have service. Second, on the industry side, you can see using SD-WAN compared to the traditional MPLS the cost about high. So there's a huge demand, whether from enterprise, from work-from-home to -- for this SD-WAN. Eventually, we do believe MPLS market probably like maybe billing, something like that. The SD-WAN eventually to feel will be replaced most of this market there because SD-WAN can deliver traffic based on different applications, and also like different cars or different rules. So the more multiple service providers. But for us, when we combine with security, you can also deliver based on like a different like content or different user or a different device or whatever the security you can see and also deliver some kind of facts networking based on SD-WAN. So we do see quite a strong demand. And also, we have a huge advantage combined SD-WAN security together compared not another SD-WAN vendor have done this together. So the ASIC chip under there gave a huge company power advantage, not just SD-WAN, but also Wi-Fi, some other networking function, 5G or is build in into the full device business supporting that.

We had Nikesh here before you, and we talked about SD-WAN for them. And he said, SD-WAN is part of SASE. It goes together with SASE, you can't just look at it stand-alone. That is, of course. Now the question is for you, can you discuss your position with Secure Edge or SASE. Can you discuss how SD-WAN and SASE connect, if at all? Just your view in general, how you participate in the market and how you connected SD-WAN to them.

Yes, the SD-WAN market is much bigger than SASE. SASE is one of the application. So you can see the total addressable market by all the research there. And I do agree with Nikesh. SD-WAN is needed in the SASE space, which is a must-have function there. But on the other side, whether a lot of work-from-home, OT security as the branch and also even within enterprise, the SD-WAN also have a huge market there. So it's driven a lot of demand in there.

What is your -- so in SASE, we have Prisma from Palo Alto, we have Zscaler stand-alone. What -- how is Fortinet playing? what's your plan on playing in the SASE market.

We do offer our own SASE solution there. And also we have a customer and grow nicely, but we did not talk a lot about it. Some of the SASE, some of the cloud secured a few -- it's a little bit crowded space. And also, we view also sometimes the service provider, even the cloud provider, eventually also have some advantage because they own the infrastructure. And it's -- I think the software some cloud is usually the first step actually building something and then the next level we really try to build in OS, which we've already done that, whether the SASE function, the 0 trust function already build in OS and then the third step go really to the hardware like ASIC or dedicated appliance. So that's actually building your like high entry barrier. And so that's why we see -- right now, the space is still more in the software approach. There are so many competitors. And I have to say most of them really losing money in SASE. We're also working more closely since like 20 years ago with a carrier service provider. We talk to them all about this set service. And even they own a lot of data centers, a lot of interconnection, but they are not having a jump in because they also see -- right now, it's a little bit losing money space. And eventually, once there's been this model turn more profit, they are probably more willing to jump in. But we're working very closely with them. We offer the solution ourselves, but also on controlled base, which makes sure we don't lose too much money in the space.

Got it. Another big topic that we spoke about today here was cloud security, and we hosted [ Luis ] Orca start-ups in the space. How do you -- do you need to change the mic? Okay. Good. Cloud security, how is Fortinet playing in the cloud security market? What's your view on the market?

I think on the number side, cloud security may be about 10% of our business right now and growing like 40-some percent year-over-year. And also, like I mentioned earlier, cloud means small network security. So we see the cloud definitely drive a lot of growth on the network security side. We also see cloud usually the first step. Like every function we have, we usually have a software version and then you can deploy in the cloud, you can deploy in the appliance. That's the first step. And second step, always integrating the OS level we call it the FortiOS OS with other function closely. And then the third step, how to make it function accelerate on the higher which will cause lower held better performance. And then -- so that's what we see as the cloud is the first step to deliver any function there, which we do believe we have pretty much all the function with any other cloud security provider or cloud security vendor there.

Got it. Maybe I want to take a step back. You have your FortiGate solutions. You have your non-FortiGate what used to call, we called it FortiGate and non-FortiGate. The non-FortiGate part, which is today, I'm trying to find a new -- the platform extension that's new one today..

Don't that sound much better than non-FortiGate.

Proper extension, that's the way. So the non-FortiGate solutions, what's the merit for you being so successful? Meaning, why are you so successful in this space? When I look at the numbers, the numbers are in the last quarter, our total revenue grew 49% year-over-year. It accounted for about 1/3 of your revenue overall, right? So what makes you so successful in non-FortiFate? Are these attached to FortiGate solutions? Or do they have life on their own stand-alone kind of platform or solutions.

Yes. I think the -- if you put yourself in the shoes of the CIO with the CISO and they're trying to manage in today's environment where they're getting attacked constantly with threats, they're trying to manage 30 or 40 or 50 different vendors. If an event -- if a cyber event is occurring inside their organization, they've got to stop the kill chain as fast as possible and it becomes that speed that you need to execute at to control that event. It's critical to your success. And if you're trying to do it over 20, 30, 40 disparate technologies, running around with your sock and your knock and trying to understand alerts and make corrections. It's extremely challenging, it's extremely labor-intensive. So to the extent that you can find maybe some more mature technologies and start consolidating them, if you will, I don't envision that any of the large enterprises are going to have a single platform, it's probably going to be several platforms, maybe one just by the cloud providers, but they're begging for some sort of consolidation, so they can respond to the threat that they see. And then if you look at the Fortinet where the -- what we offer to customers, type because of a firewall sale. That's the first sale. And the second sale may be an additional firewall use case, SSL or SD-WAN. They can also be the platform extension. And what's beautiful about it is -- it's all homegrown. It's a build versus buy company. So almost by definition, you know you're going to get that integration you need to create a platform strategy. And as you look at how we're solving a problem for the CIO and the CISO and the methodology that Ken and the engineering team and the rest of the folks have put together the problem definition of the solution are very nicely aligned right now.

What are the key components of the platform extension.

I think we mentioned about this 1/3 is cloud, the other 1/3 related we call the secure networking switch, some AP, FortiAP, some other device in the networking side, which all connect to the FortiGate and the FortiGate is the center piece of it and other 1/3 is more related to weather endpoint and some other like web e-mail security, some authentication device or the other, so it's about 1/3 each party. It's about 10% each basically.

Got it.

And maybe I would add in, going back to an earlier conversation that you were having, I don't know that we view cloud as being cloud and on-premise being either or instead of, it's rather it's in addition to. And again, my CIO or my CISO trying to control a security event that's happening real time they understand they're going to have applications that are on-premise, they're going to have applications in the cloud, they're going to have applications that are different cloud providers, and they're going to have data at different cloud providers in on-prem. And what they're looking for is a security vendor that can provide the security solution across locations across form factors for that time when they need to react to an event or as they install their own security to prevent events from happening. So we do think that they're accretive, if you will, to the entire industry.

Great. So by the way, I would just comment to the audience. If you have a question, raise your hand. I'm not going to stop at the end for questions and just -- I keep going. So if you have a question, just raise your hand. We did it before and it worked well. We spoke about products, and I understand the product. Maybe I have one last question on products and then we'll speak about verticals. And the question is, what's next from a semiconductor point of view? What is -- first of all, can you give us an update on where you are today, implementation of refresh of solutions, implementation of product and then what's next?

First, we continue to invest in the ASIC technology strategy there, which we started 22 years ago from day 1. And that's where each generation ASIC probably will take about 3 to 4 years to build. So we have a 3-chip family. The first, we call the quantum processor. The CP is in the CP9, CP ninth generation now. And then the other one can network processor is the seventh generation and which is really go to the network interface to accelerate that one. And then the third one we call ISOC, it's integrated market called CPU with other light version of NP and CP, building the single-chip solution mostly for the low end. So we'll continue that investment. And on the other side, we also leverage whatever the best in the industry, whether from the computing CPU side, GPU side or come from the networking side. And so we have all the best CPU, GPUs as any other competitor plus or on ASIC to sell the function, the GCPU, GPU cannot perform well. So that's what continues. That's where basically the investment come from the top level function to the FortiOS now has about 30 different functions, including the other networking function and then to the hardware dedicated plants, dedicated ASIC chip. If you give us like a 5 to 10x company power advantage for the same function, for the same cost. And then on the software, we do see the convergence of network security as it will cover the big industry. You can see some networking companies also starting to talk about security. You can look in the networking side, maybe about $50 billion, $60 billion space. The network security may be $30 billion, $40 billion space in the next 5 to 6 years. And I do see the converging study happening there, and we feel some of the investments we made like ASIC has some huge advantage and will drive the convergence of network security. Example is SD-WAN. We can see we're pretty successful, we'll probably become a leader now. And also, going forward, the 5G or some other like internal segmentation drive a lot of network, network security conversion also will help us keep it growing and also keep mentioning the platform of [indiscernible] is very, very important because in the security space, the #1 cost always how to manage all these like 20, 30 even like 100 products together. And most of them come from different companies, they're not designed to integrate automate together. But in the cyber security is so important to do the real-time response has to be automated response. So without the integration, it's very difficult to do the automated response. So that drive the growth of what we call the platform extension. We see most enterprise customers, they do need kind of go beyond the point solution has to be integrated plus solution there. So I do see whether Fortinet Palo Alto, we are in the best position to do all this. And so we'll continue keeping drive that.

One of the things that is hitting the industry is supply chain and maybe a question to Keith is, it's not an excuse for you, meaning for many other companies, in the space -- in other spaces, they say orders are great, but revenue growth is getting hit because of supply chain. How come? It's not an excuse for you. You mentioned supply chain, but you keep delivering. What did you do on your end? Or why is it not -- it doesn't impact your revenue growth as much as it impacts others.

Well, I'm not sure by Ken's definition that I'm making the product revenue to goal that's been set forward. But in terms of what we talk about publicly. I think the -- we try to be transparent with the investors and with the Street, and we added a new disclosure, which is bookings as opposed to our traditional billings and to keep it complex in between is the backlog number. We're in an environment of very high demand. It's a challenge for us. It's not about demand. It's about supply. And we've provided some what-if disclosures of what would product revenue be if we actually had the entire supply. So I think that the benefit you see is because of the market having such strong demand. Now behind the scenes, I don't want to anyway take away from what my operations team is going from -- going through and my R&D team. I've seen the R&D team starting very early on this process as early as last summer, redesigning products to design around shortages that they anticipated into designing more redundancy in terms of suppliers that they could provide, watching the operations team. And because it's such a long comparison of product list, if you'll suite of products, showing the ability to move key components around between contract manufacturers as I look at what was on the critical path, again going back to the problem-solving skills that we talked about before, seeing the level of effort that they've put into that. Very early on in this process, moving all of our freight, promotion freight to airfreight and incurring that cost because at the time we wanted to avoid the disruption of the ports that was happening now. We do it because we want to get the product to the customer as fast as possible. I would say also a willingness to pay the expedite fees, the chip manufacturers and others, very early on we looked at that and we said that we believe we have a price performance advantage. And to some extent, we're incurring these incremental costs, whether it's for freight or whether it's for expedite fees, we have the ability to pass along some, not all of that cost and still protect our margins, and when Ken talks about our 25% operating margin goal, we thought we were in a good position. So I think we've pulled a lot of levers there, and we -- the team has been doing it now for almost 9 months. It is an environment of constant surprises. The midnight phone calls the decommits that you hear other people talk about. We certainly experienced those things. Those are not pleasant morning when you wake up, and you find out that there's been a $30 million decommit, and now you begin the process of how do you work around that using the broker market for certain components, right? I mean there's just been a long list of things that the team has done to address this problem. And I think we've been very, very fortunate thus far, and we'll see how it plays out going forward.

Also I add on top of what Keith said, I agree is also beside, we have engineered design from a chip level to the hardware level to the -- whatever the manufacturer level operation, which we have our own engineer compared to a lot of other companies leverage third-party just-in-time supply, so we do plan all this ourselves. We also have some kind of economic scale advantage because the quantity we have right now, we ship about 40% the whole network security plans in the industry has to grow where we are strong. So that's probably more than the #2, #3, #4 of our add together, which is Cisco Palo Alto chip together on quality. So that also give us a better negotiating power. We also tend to be more long-term commit to the manufacturer, to the chip supply, and that's where the order of the new future product has been kind of quadruple pretty much from like a few hundred million to over $1 billion. So that's also give them a comfortable, give us some priority to supply things to us. So that's how the negotiating power we have and also more direct engagement give us better position to go through the supply chain issues.

Yes. And if you can just comment, broadly just on different scenarios on macro, kind of how that sort of impact your business, how you're thinking about it? And maybe what are some of the things that you're looking for in your customer conversation over some of the other indicators for you to say the demand environment is getting better or worse?

I don't see any slowdown on the demand side because the threat environment definitely gets worse and worse right now, whether within enterprise, the ransomware out like a work-from-home kind of remote access. And on the other side, a change in the industry, whether the SD-WAN and also the OT driving or some other new connection with 5G, also very strong demand for this network security. So I don't see anything slow down right now.

Yes. I think in other times where there's been an economic slowdown, cybersecurity companies have performed fairly well. And if you think about what the drivers are of the industry, more data and more locations and threat actors willing to do bad things with or to that data. I don't know that those things are as impacted by traditional economic slowdown, as you may see in consumer discretionary or something like that. That's not -- I don't know that I would view an economic slowdown if we have a recession in 2023 or something like that. I don't know that we view it as a tailwind to the business, certainly, but I do think the cybersecurity for the kind of the point I made a moment ago is perhaps different than some other industries.

In the last quarter, you're -- I'm just going to continue the discussion we had before. Last quarter, your operating margin was 22%. It's below your 25% target for 2022 or the midpoint of your target, can you discuss the drivers operating margin, your outlook, what happened in second half? Just discuss kind of the puts and takes for operating margin.

Yes, that's pretty typical for us in the first quarter because of the seasonality or linearity in the business. Q1, like some of the other tech companies. The top line is a little bit lighter than the other quarter. And then you see the acceleration as you jump into the second quarter and the third quarter on the top line. In the fourth quarter, typically, they're very, very strong quarter for the company. And we would expect that when we look at the year, that's pretty much what we're expecting to get again. So to see where we -- where we started the year at in terms of operating margin and then to provide the full year guidance, I think we're on track to what we expect in that regard.

So the commit of supply chain, all the issues we heard from other companies in the last quarter, that doesn't impact your full year guidance or full year outlook for margin?

For margin, to some extent, it does, but I think the we've, I think, baked in some caution, if you will, into the numbers. Let's see if it's enough. We talked about the fact that in the last earnings call that we could see backlog that may approach or even exceed $500 million, and that's up from $200 million in the first quarter. So we are anticipating and baking in some caution in that regard. Backlog is probably going to impact product more than it is service revenue because of the timing of revenue recognition. So it probably doesn't have the same type of impact to margin that you may expect or may see in some other industries. We do get a fair amount or a large amount of operational effectiveness as the business grows. And you've seen kind of the baseline with what our sales team and marketing team have delivered in the first quarter, and that will continue, we believe that effectiveness will continue over the rest of the year. And then we took some pricing actions in August and November and another one in February, those pricing actions have on the product line immediate impact, basically to the -- or fast impact in the current quarter. The service is because of when revenue is recognized over time. So we can see in our deferred revenue, some growth building up there and that's part of our guidance-setting process.

Got it. I want to finish with a question like most investors focus more now on free cash flow generation than in prior years. Can you talk about your position on the ability to improve free cash flow, can you talk also about -- I know there was investment in the campus headquarters in California, there was a past investment? How does it impact free cash flow generation, et cetera?

Yes. I think the -- when you look at our capital allocation strategy, and the first place that you kind of look at is M&A. And our history has been -- we do an M&A is typically a tuck-in and it tends to be $10 million, $20 million. If we get really brave, we may do $50 million or $60 million acquisition or something like that. But it's very consistent with our integration strategy. So basically, what we've done historically, we have not had to allocate a lot of capital, if you will, for that. We do -- we're very opportunistic with our stock buybacks, the second leg of where we deploy capital. And then kind of leading up to the third leg is that we will make investments in real estate. We would prefer as long-term investors, if you will, with the 2 key founders with an expectation they're going to run the business for a very long period of time that we view real estate, particularly where we have concentrations of engineers, here in Silicon Valley would be an example of that, also outside of Vancouver. We prefer to actually own our own real estate as oppose to leasing it. And we think that's a long-term answer to it. And I think there's also some items that we're looking at around the supply chain and do we want to create some opportunity to not bring manufacturing onshore because if you go all the way back into the components part of it, that's going to be very difficult to bring onshore. But there's some final assembly and test things that maybe we're looking at and maybe we're taking some steps in terms of creating some opportunities. A long-winded way of saying that we will continue, I believe, to invest in real estate, as you would expect of long-term investors.

Do you have any stated targets for free cash flow generation?

I think we provided those in terms of our midterm guidance in the mid-30% range for free cash flow margin. And I think we're very comfortable with that target.

Great. Unfortunately, we ran out of time. So I want to thank you, Ken and Keith, for your input. And to the audience, I want to advertise again the primers that we put out on the first floor on the side, I don't want to take these heavy reports back with me to New York. Please go ahead and take one for the weekend. Thank you.