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

[Audio Gap] From Snowflakes that things are slowing down. We have seen Sentinel. We've seen CrowdStrike that had some negative comments.

Some companies are reporting great numbers. Some companies are reporting some weaknesses. How do you think is the environment? What do you see in the environment, number one? And then how -- what are the components of your success, meaning you grew products 35%. You grew the services 30%. What are the components of this success?

Yes. I'll talk about just the numbers a little bit and John can give a lot more color on it, I think. I think that we've shown the ability to be a consolidator, both in terms of market share as well as product offerings, and that's given us an advantage in the current environment. As you look at Q1 specifically, I would add to that, as we've communicated previously that we saw some drawdown in the backlog that provided some tailwind to it as well. I think we saw a healthy degree of competitive displacements and opportunities. I think in a bit of a surprise, I think the SMB held up very, very well in the first quarter. And Europe held up very, very well in the first quarter. And I think when you look at those types of data points, what that really to me is affirmation that cybersecurity is not a discretionary spending item. It's a must-have. And it doesn't matter what's happening in terms of the country next door being at war or what industry you're in or what have you, you are a candidate for attacks like ransomware. And as such, you are in a position that you need to continue to invest to secure your own architecture in your own network. But maybe John can give a little more on market dynamics.

Yes, and it's all about having the right products and services. I mean, the marketplace we see by 2026, it's a $280 billion marketplace. And we break that into what we call secure networking, cybersecurity and OT security, operational technology security. And it's about having the right portfolio inside there. So secure networking, for example, where we've built things together like SD-WAN and firewalling and now SASE as we go forward, having the ability to combine those into a platform allows us to go and consolidate into the marketplace. And so it's definitely making sure that you make the right bets in the right markets, but the market is big enough. It's just a question of making sure you're going in the right direction.

The question is -- there is no doubt that cybersecurity is important, period. I mean, no one questions it. But the question is whether the behavior of the customers are changing. For example, do you see them sweating more -- sweating out the assets, the hardware assets and maybe refreshing next year instead of this year? Or do you see them signing on 1-year deals instead of 3-year deals? And things like do you see a change in their behavior because of the concern in the market?

Yes. I think you -- if you look back over the last 2 years, for example, we've talked about changing customer behaviors. During the supply chain constraint, we've talked about how customers are buying the units and not registering the units as quickly as they have. I think now as you look at the current dynamic, I do think there are changes in customer behavior, again, but perhaps in a bit of a different direction. One metric I would point to is that we're very open about our average contract term, and we disclosed how many months that is. And if you go back and look at that, you've seen that contract term go 29 months, 28, 27, 26 in the last 4 quarters. I think that's affirmation particularly as you look at the larger enterprises that there's maybe less of an appetite for doing a 5-year deal and more of a 3-year deal. So I do think you're seeing things in that regard. We've talked on the earnings call about the close rates. Close rates in this environment are different than what we experienced in 2021 and the first part of 2022.

Got it. And I know we don't have much of experience. But if you go back, I mean, you've been doing it many years. And if you go back to like previous cycles, what is driving -- at the end of the day, there were -- the industry did go through ups and downs. It was not always just a straight line up. And I've been covering Fortinet for many years, and there were some bad quarters in the past. So what is -- in what conditions do you see more of a slowdown? And in what conditions do you actually see what we're seeing today, the environment is good. So what could drive -- the question is, what could drive a change in the behavior of customers to the point where you just cannot grow that fast?

Well, so I've been in cybersecurity about 20 years. And these 3 things drive our industry. It's the infrastructure evolution, it's the threat landscape, and it's regulatory compliance. And I think right now, compared to the past years, all 3 of those are changing a lot. So the infrastructure-wise, the big one right now is people are connecting all their OT devices and factories, et cetera. They're moving applications around. So that infrastructure evolution changes the way you need to deploy security. With the geopolitics today going on, the attacks are certainly not going to stop. With the AI-enabled cybercriminals as well, it's making it harder to detect. It's making it easy for them. And then each region and country is applying more regulatory and compliance. So all 3 of those things drive our industry, and I don't see any of those things changing in the short term. Now people, I think customers, because they're building out a digital infrastructure, they want to make a good decision. So they may be taking a bit longer to decide who am I going to have for my networking to connect all my devices or where am I going to be from a cloud perspective. So they're making -- taking a bit longer to make the decisions, but they're going to make them.

Right. Got it. John, so I'm -- when I speak about Fortinet, I speak about 2 things. Number one, it's great value, meaning your prices for the technology you're providing, your prices are much lower than competition. And number two, it's a great technology. So you're not getting a -- you're not compromising on technology. So let's put prices aside because that's a fact. Let's just focus on technology. And I want to start maybe product by product to speak about your technology because I think that's what's going to drive growth for the next few years. And the first question is always legacy, right? It's firewalls and firewall platform and FortiGate platform. How do you see this market evolving? How do you see growth evolving? Are there any competitive dynamics left in the market, market share gain, et cetera? Or is it just about adding more technology to the platform so you can upsell?

Right. So we just talk about the firewall marketplace, network firewall. It's about a $15 billion to $16 billion marketplace. And I think people predicted wrongly that it's going to slow down a lot because the big use cases 5 or 6 years ago were perimeter firewall and core firewall for segmentation. And so obviously, if you're moving applications out of the data center, some of that perimeter traffic is going to decrease. And so people go, oh, the firewall market is going to slow down. What they didn't predict is that just the opposite happened in that firewalls started to be spread across all the infrastructure. So one of the use cases people didn't predict is distributed firewalls that sit at the campus, the branch, the factory going forward. In fact, today, [ Ghana ] actually refers to the network firewall as the hybrid mesh firewall marketplace. It's now 12 -- at least 12 different use cases. I was speaking to our customer a few months ago, and they said, well, I've got 2 files, I think. When I went trough all the use cases, they are 9 or 8, okay? And so for us -- so the market, the network security marketplace or hybrid mesh firewall marketplace, there's lots of new opportunity for us. We introduced that -- we talked about a new security processor 5, which is absolutely designed for the distributed firewall marketplace where you can add things like 5G and SD-WAN, et cetera. So yes, we've got great price performance. But really, the benefit is we can run more applications on there and run more use cases. And that's just one marketplace. I can talk the same about SD-WAN, about SASE, about endpoints and all the different marketplaces. You've got to have the right direction of your product to capture as many of the use cases as possible.

And do you think your growth in the FortiGate platform is reflective of your add-on products and add-on features like SD-WAN, for example? Or is there still market share dynamics like meaning you still take share from Cisco, from Check Point, et cetera?

Yes, both. But I also -- I know we talk about FortiGate, which people sometimes refer to as our appliance. I always refer to our platform as being FortiOS and the fabric. Because FortiOS to us can sit in an appliance. It can sit in the cloud. It can sit in the container. It can sit in our data centers as a SASE service offering. It can sit in an organized device and OT factor. So ability for us to put that operating system in all the different form factors and then apply consistent security is the key strategy for us.

Got it. SD-WAN as a driver, take us first through the basics, why are you so successful with SD-WAN?

Well, we saw SD-WAN coming maybe 2015, '16, a lot of the early vendors got acquired. And back then it was saying, well, let's just replace routing with SD-WAN. We looked at it and said, that's going to be an important marketplace because back then, they'll have an SD router and a firewall, so they just wanted to replace the router with an SD-WAN device. But what if we could put both together? Wouldn't that be better for the customer? And so we took a bit longer to get there, but we actually integrated full SD-WAN functionality right into our firewall. So the customer now, and we've got a -- we did some research recently by Forester. It's called total economic impact. It took 10 of our customers and looked at the ROI on putting the firewall and SD-WAN together. It was an 800% payback. The payback was in less than 6 months. I mean, the economics are just doing convergence between 2 things, firewall and SD-WAN. Imagine if you can do a wireless controller, LAN controller, 5G, Zero Trust, and imagine the economics of that. So the ability for us to put SD-WAN right in there was very important. Yes, it took a bit longer. Now we're the market leader. And we don't really know, we have to be honest, how many SD-WAN customers we've got because they can just switch it on. All our competitors charge for it. And that's why we've grown just enormously on SD-WAN. And that's what we wanted to do because in our minds, SD-WAN is that foundation. And once you've got SD-WAN in place, you can start to cross-sell back into the LAN, secure access points, secure switches, endpoint, NAC, et cetera. And you can sell into the WAN, which, of course, will be SASE and 5G and Cloud. But once you've got that platform there, it's right in the center because once SD-WAN is in place, it doesn't really matter where you use these devices are or what your applications are because the applications doing -- takes care of all of that. But that -- we thought that was the most important marketplace to win versus maybe some of the other marketplaces, which I think are easier to switch out.

Got it. So before I continue, maybe a question to Keith is how much of your revenue -- so we speak here a lot about upsell to customers, right? They have a platform and you sell to the left, and you sell to the right and backward and forward. How much of your revenues comes from upsell to existing customers versus new customers? How much of a new customer journey you still have ahead of you?

Yes. The new customer contribution in the first quarter is not large at all provided metrics over the last several quarters that we had about 6,000 new logos in the quarter. And I've also followed that out by saying the average revenue from that is about 8% to 9% of our total revenue. So you can see there's very much an expansion journey.

Got it. Okay. So going back to the strategy, and I'm taking you back in time because I want to understand. You're doing some "basic stuff" such as secure routers or switches and secure WiFi and wireless LAN. What is the strategy behind offering this basic stuff to customers? And basically, what's the value proposition there?

Yes. Well, it depends on the industry. One marketplace which for us has just exploded is operational technology. And I was talking to some guests earlier. The reason that's happened is because now all the OT technology devices need to be connected to the cloud or the application. Also, all these environments now are accessed remotely by the supply chain. I think I've spoken to 10 OT customers that have been infected through their supply chain coming in. We did an OT survey a couple of weeks ago, 75% of OT customers had a breach or some sort of ransomware attack in the last 12 months. And so for us, in that environment, it's very hard to put software and things like that. Well, as we put one of our switches in there, our switches are controlled by our firewalls. That switch port there, for example, we can apply all the security that's on the firewall on that switch port. And so for our customers, and I think going forward, these OT environments will be restricted just to oil and gas and energy. In fact, again, our campus down in Sunnyvale south of here is a mini OT environment because it's carbon emission-free. So all the campuses and some branches will want that OT security inside there. And that's why our secure switches, secure WiFi with totally integrated DAC and micro segmentation is the perfect answer.

Got it. So again, I'm taking you through the journey of the company, starting with the platform, adding SD-WAN, adding more products that are naturally synergistic to the sale. But then we have 2 new areas that are completely different. One is to secure what's called SASE, to secure the -- replace CASB, replace private lines. And second is to secure the cloud, what's called CNF. Take us through your journey in basically going into new markets in 2 ways. Number one is describe your offering in these markets. And number two is how is it synergistic to your existing customers?

Yes. So again we wanted to secure SD-WAN and the firewall marketplace first. Now we're going after what I call security from the cloud versus security for the cloud. Security from the cloud is our SASE capability provided to customers. And the ability to add that, what we call secure services edge, eventually it's going to be called SASE. I know even Gartner is getting annoyed with all the acronyms, which people are misusing. They're even coming out with a new Magic Quadrant that just says, this is what SASE means, single vendor SASE, okay? That's how annoyed they are. And to us, that's really important because now we can expand into that. We think it's mainly focused on that marketplace as it is today on remote access. But the trouble is if you just do cloud for everything, then it's inefficient. If I got to go into the cloud and then boomerang back onto my network into my data center, it's inefficient. Our view in the future is that you'll have a network and you'll have a cloud network, a SASE network. And the traffic will go in between those and backwards and forwards depending on where the application is and where the user or device is coming from. And then you will apply the security wherever the edge is. So to us, the ability to hop on one of our SASE networks then spin off a leg right into an SD-WAN network into the data center, it becomes really efficient and very secure and is much better than just a pure cloud-only solution. So again, their definition will be an SD-WAN solution and an SSE solution that works together under a single console. And that's where we see the SASE marketplace, and that's where we're investing heavily. The other marketplace, security for the cloud, we think is a bit of a different marketplace. So that SASE marketplace I think will end up like the firewall marketplace. There's probably 10 vendors there today. It's not like endpoint where there's 80. There's probably 10 vendors. It will end up being 3, 4 vendors long term because the ability to do appliances and cloud and management and security is tough. It's hard. Security for the cloud is a different environment. We absolutely believe that the hyperscalers themselves want to own all the security in the cloud, and they're going to punish you for being in that marketplace too large. Our view is that we want to play in the cloud where we can win. That will be firewalling, maybe web application and API protection and maybe some of the smaller pieces, and that's where we're going to focus. We totally believe if you want to try and be the platform inside the cloud, there's another vendor called the platform that wants to be the platform, and they're going to crush you long term.

Got it. So let's focus first on SASE and what you offer for SASE. Can you take us through -- so we know Palo Alto Prisma Access. We know Zscaler. We know maybe Netskope. Palo Alto calls it 2.5 vendor market. Where are you located in this market? What do you offer? And what are you missing?

Well, I think they're referring to the secure services edge marketplace, okay? That is remote access. They move the proxy from the data center in there. They're providing CASB and remote DTNA only, not on-premise DTNA, it's partial DTNA. That's what the marketplace we're referring to today. We believe that marketplace will turn into what we call the static marketplace with SD-WAN being very, very important inside that. So unless you have SD-WAN and a good secure services edge, you don't have a SASE solution. We believe that the journey though continues to Universal SASE that includes what we call secure SD branch. It incurred -- it includes digital experience monitoring. It includes security as a proxy in the cloud. And so Universal SASE is one step beyond single vendor SASE that includes probably 4, 8, 9 different applications in one. That will be the difference for us, the ability to provide all that capability with a single console. And there'll be some vendors who will just stay at SSE. There will be some vendors who are single vendor SASE. There won't be many vendors who are Universal SASE.

Where are you in the journey? Where are you in the process? What do you have, and what do you still need to have?

I think we have all the components. The hardest thing always with these things is making them work together well. And so right now, we just -- a couple of months ago, we released our ability for our SSE solution, our 40 SASE. One click, it spins up a spoke in the SD-WAN network of the customer with one click. That usually would take a week's worth of professional services from anybody else. That is the key going forward. That was just one example, but there's other examples, which need to do as well.

Got it. Keith in order to enable this, you need to invest in cloud capacity or data center capacity. What are the plans in terms of spending, in terms of CapEx? And how does it impact your cash flow for the next few years?

Yes. I think if you look at our recent history on CapEx, Ken has been very committed to the long-term strategy, which includes owning real estate investments wherever we can, where it makes sense. And I think the build-out of the PoPs for SASE is consistent with that strategy. The PoPs themselves are not hugely expensive. It's really a matter of the quantity that you're looking for. And I think our strategy there, as Ken has talked about, is one, leveraging the strong relationship we have with carriers and the service providers with their networks and at the same time, supplementing that with standing up opportunities in colos or cloud providers as needed. I think a pretty good proxy, when you look at the pure-play players in the market, and you see what their margins are, call it, 80%, if you will, for gross margin. I don't see a reason that it will be significantly different for us. I would back up and say if you look at the earnings call information over the last several quarters, we've talked about making investments in data centers and supporting cloud offerings in more general terms and as a component of our gross margin in services. So I think that was a bit of a message to The Street, to others that you should see and expect to hear more from us about making investments for cloud offerings. Overall, I don't see that changing our commitment to free cash flow forecast in the midterm.

Does it create any volatility with margins in the meantime or it's not significant enough to change the market?

No, I don't think that SASE and PoPs in this revenue recognition as cost structure creates volatility in the gross margin, if you will, maybe trends. But it can create fluctuations in the CapEx number.

Got it. We have less than 10 minutes left, and I want to be conscious of your questions. So we have a microphone in the room before I continue with my questions. If anyone has any questions for management, don't be shy. No? Good. I'll continue. And if you have a question, please raise your hand. Okay. I'll -- competition, and I want to talk about Microsoft. Microsoft is turning into a big competitor for some vendors. How do you view Microsoft or what's your position on Microsoft's competitive trend?

Yes, definitely a competitor and a partner. And I sometimes look at the Magic Quadrant. So we're in 8 Gartner Magic Quadrants. Microsoft are in 6, I think. But when you look at it, the different Magic Quadrants from us because there's, I think, 11 in total for cybersecurity. And so we don't roll up a bit, maybe in Endpoint, which isn't a huge market for us and SIM, which again isn't a huge market for us. And so I see it as a good opportunity to partner with them. I don't think they're going to go into the secure networking business anytime soon. And so they're a competitor. I mean, as I said, I just talked about the cloud vendors. If it's their platform, they want to own it, like they'll want to own the Endpoint, and they want to own everything inside Azure. So we've got to understand where we're going to compete and where we're going to work together. So Microsoft will be a partner and a competitor together.

How about...

I don't think we overlap as much as other vendors.

Got it. And how do you think about the other vendors, meaning do you see more price competition than before, especially now that some companies are struggling?

Yes. I mean, I think you'll see price competition in markets which are crowded, Endpoint absolutely. You're going to go the platform vendor, they will try and drive the price down, and you've got 80 vendors running around. At some point, something's got to give. But I see things like Universal SASE not that many vendors can do all that functionality. And so the bundling of the pricing components inside there will give us a key advantage.

Got it. So again, in certain markets and certain use cases, there are much less competitors than there are in certain markets.

And then maybe just jumping off a little color on that. I think we've talked before that where we see customer interest right now is more about capital preservation and payment terms than it is on discounting. And then the second part of that is on the consolidation strategy. There's a lot of us equate that to meaning taking cost out and certainly can. But I think the primary focus for the CIOs and the CISOs right now is eliminating complexity that exists with the point solution vendors.

Got it. Another question that is always important is go-to-market how -- so rewinding many years, you started selling an appliance. It's a certain type of go-to-market strategy, certain type of reseller, distributors and partners. Now it's more about services and more about SaaS solutions. How did you have -- how did you change or how do you plan on changing your go-to-market strategy as a result?

There's a change in the type of partners you need, first of all. We talked about some of the service providers and MSSPs, especially selling some of our new capabilities like SD-WAN and SASE. So there's a channel change a bit as well. But also then you have to train the salesforce themselves to be able to sell. Given our portfolio, we have 50-plus products on our portfolio, we can't train them across everything. So we'll focus on different groups like SASE or cloud. And then we'll set up what we call business development specialists who can help the individual sales teams to have that expertise. I think it's impossible to ask a salesperson to go in and sell against CrowdStrike 1 minute, against Cisco this minute, against some cloud vendor the second. So you need that -- enablement needs to be strong. You need to make sure everyone have the right tools, the right channel, and then you still need resources in the field to help them.

Got it.

I don't see us changing though from our commitment to the channel regardless of the form factor that we deliver. I think that commitment will remain.

It's the same channel, by the way, that sells SASE and sells FortiGate or FortiGate platform?

Yes, it's the same channel, but you also get specialist channels as well. Like, for example, our SD-WAN, the biggest channel is service provider because they're replacing MPLS. Now for endpoint, it's going to be one of our traditional 2-tier channel motion. So it does change depending on which product.

Got it.

And to bridge John's comment I think a moment ago, it's important that we also have a direct sales force that's bringing those opportunities to our channel and that they have the expertise that he's talking about and the training and the software and the SASE solutions.

In the last quarter, we have seen bigger proportion of smaller customers or smaller platforms. And I think there was -- entry-level platforms had a greater proportion of revenues versus before. Should we read much into it?

Well, that is a reflection of our gaining traction in distributed firewall and SD-WAN. That's where that market is.

Got it.

So you're seeing those numbers go up means that we're winning in that edge marketplace.

Got it. Okay. You started many years ago as an SMB company, and you grew into the enterprise. Can you tell us about, first of all, your position in enterprise. What's the difference between your value proposition for large customers like a bank, big bank and your value proposition for smaller customers?

I kind of modify that history slightly. We kind of started in service provider and SMB, 2 distinct marketplaces. And we've kind of come into the -- meet in the middle for enterprise. I think for the larger enterprises, they're definitely still struggling with this platform approach. It's a little best-of-breed mentality. In fact, a best of use case mentality. So inside there, we'll go through specific use cases on different vendors. And so for large enterprises, you really got to know where to go to use cases, and you go use case by use case across the different marketplaces. As soon as you come down the marketplace, commercial enterprise, they totally want a platform. And they just can't afford 40 vendors running around. They kind of want 5 to 6 platforms, and that's where we do it particularly well. But for the larger ones, it's very specific use cases we focus on.

How do you grow your position with enterprise? What do you have to do in order to better cater for their needs?

Yes. I mean, Keith talked about this. The coverage is the most important thing. As we've gone from maybe that commercial smaller enterprise into enterprise, we can't have an account manager with 10 accounts -- even 10 accounts. They had 20 accounts. You need actually -- there was around -- you need 10 account managers on the one account. That's the journey we're going through. It takes time to get the right people who know all these accounts, but that's the journey going on right now.

Yes. I think the value proposition, if you will, to get this in 8 Gartner Magic Quadrant ranking. But to John's point about having the right resources, if you will, that are sitting down with a CIO and a CISO, i it's really about the -- you can see it when we meet with customers, their ability to engage with them about their business problem and the solution that you're bringing. At that level, pricing becomes something they almost set aside on that their purchasing group deal with. They're much more interested in outcomes than they are the value proposition at that point.

Got it. Before -- I have a set of questions for margins and cash flow. But before I get there, I want to talk about still strategic level. And John, what -- if you sit today, you plan -- if you plan your product, your road map for the next 5 years, what do you need to focus on? What are the things that you want to be? Or where are the places you want to be 3 years from now, 5 years from now? Where do you have to put the focus?

Yes. To keep converging. And as I said, we have all the pieces. We just got to make sure they're converged and managed and simplified. Endpoint is a good example for us where we actually have a very large installed base of VPN, EPP and now ZTNA and SASE. And we can add EDR to that going forward. So if I'm a customer and I go, if I can get all 5 of those things in a single agent, that's great for the customer and great for us. We don't have to use all of them, but they're all there. So convergence at the endpoint, converging in the network, converging in the cloud is where we're focused on and making it all work together end-to-end.

So today, the technology that you have is still not converged, meaning that's what you need to work on?

No, pieces are converged, but we still need to keep working on the conversion.

Got it.

Like I say, we have 4 pieces on our endpoint. We'll add EDR at some point and other capabilities. We have a SASE capability, but do we have a simple one button that presses and adds capabilities like CASB to every application -- so you just got to make it easier for customers as you go forward.

Okay. Another word for it is automation.

Automate as much as you can.

And actually, that leads me to my next question, which I'm going to ask everyone today, and I think that by the end of it, we'll be sick of this question, but how AI changes your life.

My personal line?

No, company life. Personal life, I'll ask later. Now I'm going to talk about company life.

I think it's going to change every part of our business. And we've already been using machine learning and AI in our threat research, et cetera. it makes it -- as I said before, the bad guys are also using that technology against you. We'll be using it in our network operations. For example, our AI ops can look at why something is not working in the Internet. It pinpoints exactly where it is and fixes it. We'll also be using in our support services, et cetera, et cetera. So I think AI will be used across the whole business but in different ways. And you can't just say this is AI and apply it to this. You've got to make sure it's adapted to each use case.

So that's in automation, right, mostly? Or...

Yes. But I think we just had a report from ESG. And I think your question about the budgets earlier, I see a lot of businesses, they still got to drive that digital business. So they still want to build secure networking. So I'll still invest in that. I don't see many customers at all saying I'm going to stop investing in cybersecurity. But what they do say is I've got to react faster. So we just did a report saying that if you connected your SIMs or an EDR together in an automated way, you can go from a 12-hour mediation to 3 minutes. That's what they want to do. They want to be as fast as possible in discovering something and then remediating something. So automation means different things for networking versus cybersecurity.

Got it. Got it. I got the note. Okay. Thank you very much. Thank you.

Excellent.

Thank you.

Thank you.