Fortinet, Inc. ($FTNT)

It's very easy with Bank of America. Whenever someone leaves, they ask me to cover it. So I cover software and data centers and cybersecurity and networking. So one man show research. But I'm very pleased. I know this space extremely well. I've been covering it for 15 years, almost 20 years. And I'm very pleased to host Ken Xie, CEO and John Whittle, Chief Operating Officer, and we are going to speak about the fundamentals. I want to talk about the quarter but very little because I really want to focus on the fundamentals and what's coming for the next few years.

With this introduction, I'll start with the quarter, I can. The quarter was unique because the numbers were very strong. The billing growth was 31%, secured networking billing was 32% up, Unified SASE was up 31%. And the question is what drives the growth both of the secure networking as well as the new areas?

Like I mentioned in the earnings, we see the AI actually accelerate, we call the convergence of network in network security, especially within the enterprise because AI definitely drive a lot of additional traffic, whether it agent or using some AI for certain applications. Most enterprise today, they only have the , they call the parameter security. Internally, don't deploy much network security whether to do the internal segmentation or protect some key server or certain departments and data there. So that's where we see the strong growth actually come from the enterprise for us, right, the middle range FortiGate product. You can see the product revenue grew like 41%. Not much comes from this supply chain price increase. It's more come from the new demand and at the same time, there's other area, whether the OT security, we see like a 70%, 80% growth year-over-year and some other data center building because we have a huge advantage on ASIC performance, more function to support this high-speed network environment, network security. So we see that also in the early stage ramp-up right now.

Yes. There was concern after the quarter that maybe it's early ordering. People are concern investors were concerned that maybe this is not sustainable. So how much of it? And can you know actually if it's early ordering of customers?

We actually managed the channel inventory managed for quite well. And also, we told customer partner or trade. We will maintain the same margin. So if our costs go higher, we may address monthly -- and like this time, we do read some of the price on the product side. But most of service, we did not catch only service a percentage of the power price. But right now, we see some kind of memory, some component link with maybe temporary, maybe I don't know how long it will last, maybe a few quarters or maybe. But we also -- if you look at the last time, 5 years ago, when the supply chain issue there, we reached the price in the beginning, and we lowered the price when the price come down also. That's worth for us the policy to maintain the same margin with gross margin around 80%. I feel we build a trust with our partner customer and also, we told them no need to pull forward. We also have some policy once you bought the product. If you don't deploy within 90 days, we automatic trigger the service revenue, all these content we call FortiCare. So that's where there's no incentive for keeping excess inventory for the partner, for the customer.

And we've been seeing kind of sustainable growth drivers across all 3 of our pillars, OT, et cetera, for many quarters, but well before we increase pricing. And this is even before the AI tailwind, which to us feels like a sustainable growth driver as well. And so we see that momentum well before the price increase, like Ken said, we manage the inventory. We're not seeing increasing in stocking orders. So it feels like the sustainable growth drivers have been really strong before the AI tailwind, and now that's a new sustainable growth driver that is really accelerating that growth.

So I'm trying to understand the AI tailwind. Agentic KI is not a big driver yet in terms of deployment. The numbers are small. When I look at companies even like Salesforce, we're presenting after you, it's $1 billion of orders out of $50 billion of revenues. It's not a big number. Why do we see AI as a tailwind already now before actually we see agentic being adopted?

I think only the revenue come after people starting using all these things, right? We see the interest pretty high. If you talk to a company inside pretty much everyone engineer, they try to leverage AI now and even a lot of like sales force, their customer support, they say maybe 80% not handled by AI. And then there's a lot of other even G&A or even -- that's where we see a lot of our company, they started to try to see how AI can help them how AI changes since there, that's where see the AI, we see the increased company traffic within the company, probably like some let's say, 20% some 40%. They do have increased company traffic within their own kind of enterprise environment because this is usually inside the company, especially all this AI, agentic AI. That's where the traffic, the traditional network security, they will security parameter. They don't see how internally. Thus, we see the biggest growth come from the middle range, which we see the customer more deploy inside the company we do the internal segmentation is kind of internal securities.

Yes. And I would always categorize it into 3 buckets. -- when I think about the growth drivers and there probably are others from AI. The AI tailwind, you have kind of the elevated threat environment in general with AI tools. And I would put those in that category even though I think people are worried about methods or the equivalent functionality becoming public and then their entire software surface could be exposed. So I talk to CISOs a lot, and they're very concerned about that, that's impacting buying patterns in addition to the increased threat level with the AI tools that are out there, then you also have the AI sprawl within organizations. And people are very concerned about that. CISOs are like, I don't even know what's out there. The A lot of this is shadow AI. And then you have AI data centers, and we're seeing a lot of investment there. Security is a big portion of that. And you see billions of dollars being invested there. a portion of that is going to security, and that will be a sustainable driver over time.

And where is this demand? What kind of customer? Is it bigger -- so if I rewind back, I don't know, 20 years you started from the SMB market and your product specs the fact that you are low latency and features brought you into the enterprise space. Where are we seeing this? This time, you spoke about sovereign AI, this time you spoke about. So where do you see the demand as a result of the AI cycle? What kind of customers I mean?

I think like in early Fortinet, we move leverage the channel, right? So it's doing well. And also when the IPO 17 years ago, it's like over 30% business come from, we call the service provider -- telecom service provider. Now we see not only the enterprise try to get better visibility internally, but also some service providers in come back, where there's some AI service provider. There are also some kind of a hyperscaler working with us, but also whether the sovereign AI, sovereign SASE, also, we see a huge market opportunity for us. We gave a few examples during the earnings call, which I feel some of our competitors not address that market yet, especially like a sovereign AI, sovereign SASE, they do need to deploy on their own infrastructure on their own premise instead of what the cloud deployment for a lot of like a SASE player there. So that's like a 2, 3x bigger total addressable market and then the cloud, AI cloud SASE there. That's where we see huge growth there. And also, I do believe a lot of service provider will be very, very important kind of ecosystem like 17, 20 years ago when we IPO, that's where it could be even driving the biggest market segment for whether AI and SASE.

John, in general, what can you say about the sales cycle, the pricing environment? What -- where are we in terms of the risks to the business model?

Yes. I think if you look at our business, it's very well diversified across geos, solution sets, our 3 pillars and OT across customer sizes, across verticals. It's a very diversified business. And we see these sustained growth drivers across all of those different sets. And so we're not seeing risk to the business -- if anything, we're seeing a little more urgency in terms of these conversations with Fortinet and the CISOs are coming to us for help in this new AI environment. So we see a lot of demand. We see a lot of momentum. It was reflected in our Q1 results. We saw the demand picking up before that as well, and we feel that demand right now. So we're not seeing risk. I mean the -- our big opportunity is to address the demand, and we've got to just move really fast to make hay while the sun shining. And it feels like for the next 3 to 5 years at least with a company like Fortinet where we have the scale of solution set, great solutions for this environment. The momentum is very, very strong across our diversified business.

So I'm trying to understand the secure networks, you had very strong growth of orders, and you spoke about traffic, Ken. You spoke about traffic going up. Checkpoint reports weakness in firewalls Palo Alto says the firewall market is growing 5%, you're growing 31%, 32%. Where is the disconnect? Why are you more successful than the others? And by the way, sorry, just to -- maybe I'm not comparing apples-to-apples, so if you can expand on what's included in it.

Yes. Actually, the product revenue in Q1 grew 41%.

Right. That's the problem.

[indiscernible] compared to Palo checkpoint whether single digit or even negative like Cisco. I feel kind of -- you've seen the -- if I look at the Beshar,also in the investor presentation, and using the CI to describe this long -- you are the only few analysts in this space for like 20-plus years, right? So the first eye is the innovation, because if you look at Fortinet probably the only company or in few company, we internally develop SASE, SD-WAN in the passage firewall, some box and app control, all these things. And then that's where 1 company keeping growing, also keeping catch up the new wave, the new like function needed, that's very, very important. -- like some companies, they're starting falling behind when they bigger, they cannot internally innovate. That's where the first eye. The second I call the integration, so when you develop internally, you can more integrate easily in a single OS. So [indiscernible] about 30 function now. So if you depend on acquisition, the integration is more difficult like how Cisco Plato, when they compare whether SASE or before they have a separate box have solution to cover SD-WAN, cover SASE cover all these network security, all the things there. So they cannot have a single integrated solution. In the network security, single inversal are so important because online to deploy multiple box in mind. That's for in the network security space in the last 20, 30 years, most are on single point solution company all disappear. And only the platform win in multiple function integrate together as well. That's the second integration. And then the third I call the improvement which Fortinet very unique. So from day 1, we developed ASIC to improving the performance, the additional computing power can enable more function, lower the cost, lower the energy consumption. And also, we're also the only cyber secure company invest in our own global data center infrastructure. So we own the data center. We own all this kind of like a 40 stack with 1 software. So that's making us a 1/3 cost compared to other SASE player. That's where the 3 innovation integration and improvement ASIC or the infrastructure that gives us advantage for the long term. That's why a few the market itself probably grow around 10% year-over-year. But whoever can keep in this -- gaining market share, that's why we were confident, I say multiple times in the last few years. We are very, very confident to grow faster than the market and keeping gaining market share, which some of the players starting falling behind.

Yes. I think it's also a competitive advantage that we have been very focused on that network security market for 26 years, and there's no competitor that's been focused on that in terms of investing for growth checkpoint was more focused on profitability. [indiscernible] they're getting out of it. Cisco, sometimes investment security sometimes doesn't. And we've been very focused on that market, and we're seeing a lot of demand for it. I think some of the market growth rates may have been understated, which may have helped us a little bit because people don't view it as a shiny new object, but we've been very loyal to that market more than anybody else and that investment kid's talking about in the technology is really putting us in a good position right now.

So Ken spoke about the 3 Is, and you touched at the end about SASE, I want to go back to Unified SASE, just to ask simple question. why are you growing so much faster than the others? And who are the customers? Meaning, what is the addressable market you're going after from a profile of customer on view?

Yes. I think the differentiation is really report for SASE and SD-WAN and all the major firewall security in the same OS. So that's -- it's very easy quick for customers to adopt, SD-WAN SASE that's where in the last few years, we already become the #1 SD-WAN player because SD-WAN is part of [indiscernible]. Now SASE part of the [indiscernible]. That's also like 90% comes from the customer nation from like network firewall to SD-WAND to SASE. Just in a few minutes, they can get SASE deployed. On the other side, we also the only company invest in the SASE infrastructure globally. It's part of some other service we have FortiGuard, [indiscernible], which also leverage all this data center infrastructure. That makes us a 1/3 cost much lower cost compared to have to using cloud providers and other colo. So that's other huge advantage. And then the third one, so the first one I call 3 in 1, right? So [indiscernible] the second quote like 1/3 of the cost. And then the third one I say the 3x the market size, like a sovereign CRC, on-prem sisal these appliance which the competitor not addressing, they don't have a cloud asset approach. We see the sovereign state growth so strong. There's a lot of service provider carrier. We took it example. They just said, hey, SASE be huge potential for them, just like 17 years ago, the [indiscernible] a big potential business for them. So they're starting quickly adopt the sovereign SASE using our box on primate in their own infrastructure, deploy SASE as a service for their customer and keep the data within their own infrastructure. So that's where the solvency SASE as a few will make our market -- total addressable market like 2 to 3x compared this cloud SASE in the other player play and all be competitive. So that's a few as SASE like you can see the Unified SASE Q4 grew 4%, Q1 is 31%, 32% faster than any other SASE player and also we're bigger. And so that's even starting call SASE firewall, right? It's the same operation system, the same box. [indiscernible] SASE together base firewall. That's where sometimes in Q1 is a little bit difficult to differentiate because in secure networking, the most growing the FortiGate, which is like maybe 87% business there. Because for us, the cells have no incentive where identify the SASE or firewall. So both business grow like 30-some percent. So it's both pretty strong. But we do see SASE we have a huge advantage even using the SASE [indiscernible] a ton, which is -- SASE is just like a few years ago, all the same box being integrated to the firewall than the sandbox we is kind of disappear. And also [indiscernible] traditional firewalls. SASE started replacing some of the nonsati SASE firewall and part of the whole network solution now.

Got it. Is your SASE offering today at par with competitors. I -- because I stopped covering you about 8 months ago, and I started covering you about 2 months ago, there is a 6-month gap in my knowledge. So back then. when I let you...

[indiscernible]

You are still ramping the feature set of SASE. Where are you today in terms of competitive position?

Actually, we do see very, very strong demand for the SASE and you see the ramp up pretty quick. What's new in the last 2, 3 months, really we started launch we called 2 bundled service bundle, SASE, SD-WAN and all these other service together, which for the existing customer is 35% for the hardware cost per year. And then -- but that's also -- if you bundle all these kind of 4, 5 service together, it's less than 1/3 of cost you buy individual, because in the past, I think when we do offer SD-WAND of the 4 function, but we don't care my service. They don't have underlay overall service, but only the work top customer buy it. So when we bundle SD-WAND SASE altogether, it's also like 50-fee-license part SASE , we see the drive of this bundle service growth [indiscernible].

And we are seeing the most discerning enterprise customers by our SASE in very competitive deals. So we're seeing an increase in that. And I think we're really kind of distinguishing ourselves versus some of the single solution providers out there who don't have the optionality of sovereign SASE and cloud SASE. And I think you see that in growth rates and stock price performance versus like a Zscaler or a -- and so I think kind of the the winners and others may be -- there may be a trend where that's started to separate a little bit.

Yes. On the last call, you said, if I remember correctly, and if I'm not correct me, that you're 18% penetrated within customers with SASE?

Yes. For the enterprise, we're tracking.

Right.

Probably 70% already used in SD-WAN but 18% now using the SASE now, but also that's probably about 50% growth compared to 1 year ago. It's a pretty strong growth for the current customer base quick up from like a firewall to SD-WAN to SASE.

Got it. You touched on sovereign. For those who don't understand the difference, can you explain sovereign SASE, what is it and what is the market opportunity?

Basically, you can process all the data within whether customer on-premise, we call private so in their own kind of infrastructure, like certain countries, certain service provider 1 have data being processed with their own infrastructure instead of for to the cloud? That's the one you do need to provide them the product to process within the own infrastructure. Basically, sell in the product first and then they kind of using the product offer the S service to their customer base process locally.

Got it. And is this a U.S. phenomenon? Or is that the outside ther U.S. .

[indiscernible]

Okay.

U.S., we do have a few bigger enterprise petafinance service. They do they call the private as. They're using their own data center infrastructure to process data on their own premise.

The other parts of the business also grew very well this quarter. Talk about the other parts. OT, I mean, take us through the journey of the newer parts of the portfolio outside of SASE?

Yes. I think OT is the one we say grow like 70%, 80% year-over-year. We're kind of focus in that area in the last 5 to 10 years. And we don't see much other players get into this space because it kind of -- there's a lot of unique protocol. They also sometimes need a special hardware in the recoded form in this outdoor environment. That's where also kind of don't need some kind of long-term investment there. On the other side, you can see IoT space which probably a lot of time now, probably most of the time, network security may be the only way to secure that environment, because I'm pointing pretty much impossible to deploy in this OT IoT device, which has a very limited computing power via different operation system which is the traditional endpoint solution now working. So the networking security is probably the only way to protect them. So we see a huge market potential, especially all these edge computing, all this kind of a connect device, all this since -- so that's where we are probably the last 3, 4 years, if you -- there's a market report, we are probably the only leader in that space. That gave us a huge growth potential advantage there. I feel with us probably keep in saying in the next 10 years, probably there's more 10x more device connect than people if you add like maybe even 100 times.

Yes. Security operations, think about how central is security operations to the broader platform?

We just try to help customers to quickly automate our network secure operation. So we have about -- actually about 40 products in our portfolio there. Now over half, more than 20 has all built AI capability inside like AI making all this decision automatically so they can react more quickly within second. So that's also -- as well as more like up sell, cross-sell. So if you look at secure up, it's a very huge market, almost like $200 billion. But I do believe probably no player even have a double-digit market share. They are so fragmented, right? So that's worth for us, probably like around 10% business comes from the secure OP, but more from existing customers up to our cross-sell. And because we develop most of the product in-house, -- they integrate like automate will get much better. So that's where kind of we feel that the advantage we have, but it's on the other side, it's a over fragment market and we still are focused on network security right now, but a lot of customers, once we get in, we're starting expanding into some operations to help them quickly alter.

We are also seeing a lot of kind of mid-sized customers who buy across the 3 pillars, Secure networking, SASE and security operations and MSSPs who love the full portfolio because they can offer it as kind of an a la carte menu and sell additional amounts. And they're also expressing interest in some of our AI visibility for the AI sprawl, so they can help their customers identify the AI sprawl throughout the organization. And secure it and have cost control around it as well.

Is this a stand-alone product? Or is it normally sold with the other parts?

It's typically an expand sale. So it can be a stand-alone product, but more often than not, it's an expand sale. And oftentimes, these mid-market customers will buy across the portfolio. And we see the bigger customers consolidating vendors as well, whereas they may buy from multiple vendors. But I think that kind of broad platform approach and opportunity is pretty significant in mid-market and below.

Yes. When we measure cybersecurity companies, very often, we look at how much business is coming from new customers versus how much business is coming from an upsell. Especially now when we talk about platforms, upsell is a big part, but also new customers is a big part. So talk about your situation, talk about kind of business with new customers versus upsell to existing customers and -- and how do you go to market differently about these 2 things?

I think for us, we definitely want to take care of the existing cover for the new security need, that's how we kind of keeping up all this space changes, whether the now SASE with [indiscernible] computing with our AI. So we try to internally develop the same new function in OS, make it very easy to migrate to the next function they needed. On the other side, we do see competitors starting whether falling a part behind, which make us also gaining a lot of new customers, especially like U.S. enterprise. You can see it's very strong growth. So if you look at the 10, 20 years ago, there's a top 5 player has less than 50% market share in network security. Now probably the top 2 players already have over 50% market share. So they do have some consolidation going on and I do believe we have more advantage than other competitors keeping gaining market share. That's why we were confident we'll grow faster than the market in the next few years. And at the same time, we're keeping gaining market share.

We're almost running out of time. I want to talk about supply chain. Any constraints? How do you handle supply constraints?

We managed this multiple times. And just like 5 years ago, we told our customer partner, we just want to maintain the margin and we don't want to make more money or whatever to the real-time adjustment. And we also have a 6-month inventory, and at the same time, because we have like almost 60% market share on the unit shipment in the space, we're able to operate manufacturer working with all these like memory supply, the CPU supply, the network chips supplied directly. So we're working with the chip company directly to sourcing all this I think has a better source capability, more long-term commitment contract, make it more stable. And at the same time, the policy of excess inventory helped us during this time to gain the market share, which a lot of competitors probably don't even have the product or shipping that we say there's a 1 of 5 to 10-year opportunity to gain market share, we bet this way.

Got it. And do you envision maintaining this leadership? Or what is structurally right with you that is wrong with the others. I mean why are you structurally able to handle supply constraint better than the others?

We're trying to be more long-term focused. I don't think any other of our competitors try to keep in 6 months inventory for the key component like on -- as we keep even 1 year inventory. So there may be lower some operation cost short term, but missing the opportunity, which I feel if we don't have this, we missed -- there's the opportunity cost if we don't do this. And so that's a few -- some kind of -- maybe we go through this a few times, a little bit better than competitor. But I view this is the opportunity to gain market share.

Got it. We're run out of time, but I can still a minute or 2 from the next -- from the break. Any question from the audience? right? So I'll let you go. Thank you.

Thank you.

Thank you.

Thank you so much.