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

All right. Fantastic. We will go ahead and get started with the Fortinet session at the Goldman Sachs Communacopia and Technology Conference. I'm Gabriela Borges. I cover software here at Goldman. Delighted to have on stage with me, Ken Ji, CEO and Co-Founder; and Christian, CFO. Thank you so much for joining us today. Thank you. We...

Thank you.

So Ken, one of the ideas that we're exploring real time is this idea of a cyber frontier model within a cybersecurity company. And the thought process is, as a cybersecurity company, you have an incredibly rich proprietary data set that you've been hearing for 10, 15, 20-plus years because ML has been at the heart of Fortinet's road map since the time of its founding. How do you think about what a frontier model, a cyber frontier model within Fortinet could look like?

We definitely developed a lot of our own expert model and also kind of probably maybe not a company also build own infrastructure, including the global data center with GPU and already launched more than 20 AI-enabled products, more in the security operations side. Like I said, the data is super important, like we have a majority, more than half the global network security deployment, give us a lot of data to an the global like intrusion attack landscape there. So that also fit in our own kind of infrastructure model, the kind of AI infrastructure, we feel we have a pretty good view of what's happening globally. But definitely also you need to use AI to fight or protect the other AI, which we feel is driving the huge growth going forward, which is really the new market. We have not seen since we did Analyst Day 2 years ago, which is a huge opportunity, including both the enterprise level security, which we see a lot of like internal segmentation, which is really the kind of the machine general traffic actually is a huge increase. At the same time, some service proper, especially the near cloud provider, I hope that market for AI service provider near cloud probably can be bigger than the traditional carrier or some kind of a security service provider because definitely changing the whole landscape both in enterprise and some service software industry. So that's where some PI service provider will play a more important role, especially in the security.

Let's stop on the AI service provide trend. So when I think about one of Fortinet's strengths with the cloud cycle, it was with the telecom service providers and that has been a core part of your business for some time because of the performance and cost benefits that Formet delivers. Talk to us a little bit about what that looks like with the AI cloud cycle now? And maybe as part of that, the opportunity that you may have with neoclouds, for example. .

Yes. It's -- I think, first, -- like just like a SASE, we always believe there is a bigger market for service provider or even on primate sovereign sits the same thing for besides the frontier AI model, and there's always some service providers. There's always some kind of on-premise AI SASE kind of security because they want to keep the data in their own kind of infrastructure process locally, not just some international, but even some big company in the U.S. at the same thing that actually drive the AI security also drive some kind of a neocloud. It's a similar like sovereign SASE, we feel is a huge market and bigger than the cloud only as by some early a provider. The same thing for AI security, the new cloud that had other layer of service and compared with some hyperscaler. So that's the part we feel eventually it will drive more kind of security need for whether sovereign AI or some other local AI security market. Probably Christian, I also see a lot of -- especially from Europe, there are certain regulations.

So I think that the opportunity for us because we developed a technology stack that others can operate, whether it's the sovereign outtake the it is the infrastructure security for clusters. We see us well positioned for more of those regulatory environments where solvency is mandated. And especially in Europe, there is a lot of initiatives right now to build out AI infrastructure through local companies, right? And we want to be part of that journey, the security journey for AI infrastructure. similar to how we are partnering with global telcos on building out of Insafe. And that has been a theme for net for a long time. that we partner with others to help build out infrastructure. And so I think right now, it's an inflection point with more infrastructure going on-prem, not only going to the cloud that net is well positioned. And especially on the AI side, not only for service providers also for enterprises. Cloud AI frontier labs are expensive and sell more and more customers are rethinking how much they should do themselves and build out their own GPU clusters and secure them and deploy outsourced models versus using AI and through the fronter labs. And I think that's going to be a long-term theme that's going to play out over many years.

There's one key difference compared to the traditional carrier service provider to the near cloud provider. The new cloud make decisions much faster. They make decisions in months. You can see we gave example in earnings like Q1, there's a new cloud 1 of -- they evaluate the starting to purchase the same quarter for a few million. And then Q2, they're stated like a 5 to 10x bigger -- you can see they make decision in months compared to the traditional carrier service provider, they take years to evaluate and make decisions. And we feel with pretty strong growth but also in the early stage.

Maybe let's talk about early stage going to the longer-term dynamics that Chris on mentioned here. So tell us a little bit, Ken, you just mentioned. I think you said near cloud, they make an initial decision in 1Q and then you can see 5 to 10x bigger of a deal in 2Q. Did I summary right. Maybe just talk a little bit about the progression on what you're seeing in the pipeline. And a lot of us from the outside, we try to track CapEx. Is that the right way to think about what the trajectory of Fortinet's data center neocloud business could look like over a 3-year time frame? Or any color you can give us on how to think about this opportunity?

It's still pretty early stage. It's difficult to like compared to the traditional carrier service provider, they have like 20, 30 years or whatever the history we're working with them. So we know their model, all this quite well. But near cloud, they are still in the ramp-up stage, but they have a huge capital. They have a huge infrastructure they try to build I feel is still more in the early stage, more protect their own infrastructure or build up like if you look at different layers, they are mostly in like infrastructure layer right now. They're not quite protect the model application there yet. But once they're starting to offer the service in the higher layer definitely, there's other wave of opportunity. Right now, it's really more -- they're building infrastructure, protecting infrastructure, could come from like a utility energy OT layer could be the infrastructure of this layer, but they are making a decision they move much faster. They see the demanding for their AI cloud service is a huge.

And I talked, I think, in the Q1 earnings release about putting out reference architectures, right? So the neocloud won't buy and put it on the shows, they would buy firewalls and related services as they deploy the data centers. And so it's critical for us to be in early so that we can grow with them. And so that's where most of the midsized nail clouds are probably more likely to be our customers because they won't have the custom components, proprietary components.

Yes, that's where the ASIC advantage pondages are huge compared to other competitors in our space.

Christiane, started talking a little bit about enterprises running more agenetic processes, more open source or open rate models in-house. So my next question for you is how do you both think about network traffic at your customers. And maybe there's 2 pieces. There is the clack firewall. When do you start to get a bottleneck in throughput because the genetic activity has gone up and then on the sovereign SASE piece. I'm already seeing a change in network activity, but the agent and 1 of the implications of that. So maybe we'll do the data center, the classic firewall north-south traffic question first.

The classic data center, I would say customers just start building out their own infrastructure as they see cloud costs increasing month over month. And as they also see what do they want to do with AI? And so we have the partnership with NVIDIA, right? So we are securing GPU clusters. We are also doing it internally. And that's a big market that customers -- enterprise customers are increasingly interested in. And on the -- your second part of the question was on the SASE side, right?

Yes. Are you seeing an impact in your SaaS network. When you look at your network capacity versus the amount of network traffic -- are you starting to see the trajectory of network traffic change because of agentic activity?

Put this way, probably the recent AI treatment traffic it's more like the East West traffic, whether within the data center within enterprise. And also a few months ago, probably is well known is that the first time machine to merchant traffic over passing the human emersion traffic on the whole Internet now. That's where the enterprise, they definitely want to have a better visibility, better control, especially in their own data center compass, what kind of traffic, what kind of since agents doing there, that's where we see increase of this new internal segmentation, replacing the traditional network device. That's where the convergence we talk about for like 20, 30 years, starting accelerate by this AI kind of adoption there. But also there's a lot of new areas, which whether the near cloud, there's the sovereign casitas beyond the traditional network security doing there. And that we see is a new market opportunity compared to the traditional whether network security or kind of replacing whether network security or kind of SD-WAN is where we see a new market especially the on-prem or SASE compared to before the cloud on from our feedback, most enterprise like this hybrid model. They do need on-premise. They do need some kind of sovereigns, but they don't have much choice before. So somehow, when we combine this SD-WAN, SASE firewall together in the same OS can be deployed on premise in the cloud of business service provider has opened up a huge opportunity for us. And we see quickly not only the new market, but also kind of starting to replacing some of the existing players.

And then to the point, customers are buying higher FortiGate compared to the past. And how do we assess this? Basically, the average ASP for us is increasing, yes, net of price increase -- so we see true ASP increases, which suggest that within each band, low and midrange and high end, they are buying bigger devices. What we don't quite now, of course, is whether they are buying bigger devices because they are planning for more network security traffic or whether they want to deploy more of the functionality, whether it's SD-WAN, whether it's quantum encryption, whether it's all the AI visibility that comes with the new OI. That's hard to say, right? But we definitely see that customers are preparing for more requirements, more cybersecurity needs and all the functionality and innovation that we are constantly rolling out with our OS version, yes.

I'm curious how we think about -- it's a little bit of a pricing question. So you're talking about an upgrade cycle where previously, if I would have bought a firewall at ex-cat capacity. I'm now buying 1 size up. What is the typical pricing delta between the different SKUs or cohorts? Is there a way to frame that?

It's very different by low end versus high end, right? The high end has -- big differentiation between the 1,000 model and signs, right, versus in the low end. But it's meaningful from a...

Yes, that makes sense. What is the AI visibility that's in the new in the new OS.

There is a lot more functionality as to AI's ability which -- where is the traffic going, which model traffic is sent to what type of auto contextual, what is there kind of personal data in the prompt and some. So a lot more visibility that we are providing through the FortiGate and related product that customers may want to deploy when they have more agentic traffic, more sanctions -- and they want to sanction the use a little bit more in their company, yes.

Yes. Also a few -- because some pay models starting market on funding like vulnerability hole there. And we're working with all the frontier company kind of try to quickly helping customers defend this kind of vulnerability. But I say it's still probably most vulnerability still not in the wild yet. But on the other side, we keep important customer. Maybe you need to quickly patching, quickly whatever, but I feel some customers still behind and not also probably -- some other customers, they just try to buy some extra layer protection whether by internal segmentation or protect the new tech surface or even add multiple-layer defense like the network security, you are the first layer because if you have more vulnerability in whether OS layer, browser application, definitely the network isn't helping defend in the first layer. That we see also kind of increased the business for us, especially in the enterprise space.

How much of this change in buying behavior, and we'll talk now about some of the cyclical dynamics in your business as well. But I'm curious how much of a change you've noticed in customer behavior since early April when some of the more advanced frontier models first came out. How much of some of these dynamics that we're talking about can be pinned or isolated to that type of dynamic?

Definitely not we reached some awareness. There's some day, some AI like whatever security outbreak maybe happen. But it's -- that's where we do pushing customer need to be upgrades sooner and -- but they also have their kind of balance because there's certain operation cost upgrade. There's a certain like a budget or some other things they need for the extra protection there. But I feel -- yes, we'll keep working with them and before the big whatever things may happen.

But in general, I would say, these discussions have helped with advancing security -- cybersecurity discussions to the executive level it was there before, but now I think the need for doing something if you have aged environment is very clear. But -- it's a combination of factors. It's not only metals, right? It's also the nation's stated tax, whether it's in the U.S. on the water infrastructure, whether it's internationally from Russia on the infrastructure in Europe. So there is a combination of companies being afraid of more attacks, less time to identify them from AI. And then also the threat environment increasing from other actors that are out there in the world from geopolitics. And that both is, I think our advancing discussions on investments in cybersecurity and how to best secure your infrastructure against these accelerating threats.

Very good. All right. Let's talk about the memory environment. bring us up to speed a little bit on what you're hearing in the field about customers -- from customers specifically around pull forward on the firewall side because of memory pricing.