Fortinet, Inc. Q2 FY2020 Earnings Call

Thank you, Chris. Good afternoon, everyone. This is Peter Salkowski, Vice President of Investor Relations at Fortinet, and I am pleased to welcome everyone to our call to discuss Fortinet's financial results for the second quarter of 2020. Speakers on today's call are Ken Xie, Fortinet's Founder, Chairman and CEO; and Keith Jensen, our Chief Financial Officer. This is a live call that will be available for replay via webcast on our Investor Relations website. Ken will begin our call today by providing a high-level perspective on our business. Keith will then review our financial and operating results for the second quarter, provide some additional details regarding our second quarter performance and some insights into how July performed before providing guidance for the third quarter of 2020. We'll then open the call for questions. Before we begin, I'd like to remind everyone that on today's call, we will be making forward-looking statements, and these forward-looking statements are subject to risks and uncertainties, which could cause actual results to differ materially from those projected. Please refer to our SEC filings, in particular, the risk factors in our most recent Form 10-K and Form 10-Q for more information. All forward-looking statements reflect our opinions only as of the date of this presentation, and we undertake no obligation and specifically disclaim any obligation to update forward-looking statements. Also, all references to financial metrics that we make on today's call are non-GAAP, unless otherwise stated. Our GAAP results and GAAP to non-GAAP reconciliations is located in our earnings press release and in the presentation that accompanies today's remarks, both of which are posted on our Investor Relations website. Lastly, all references to growth are on a year-over-year basis unless otherwise noted. I will now turn the call over to Ken.

Thanks, Peter, and thank you to everyone for joining today's call to review our second quarter 2020 results. We are very pleased with the solid second quarter performance. Revenue increased 18% to $616 million, with product revenue up 12% and service revenue up 22%. Secure SD-WAN climbed to 12% of total second quarter billings, the first time it's been over 10%. In today's environment, enterprises are focused on effectively and cost-efficiently deploying security across their physical and digital networks. To meet these challenges, Fortinet was founded on the vision of bringing security and networking together in what we refer to as security-driven networking. Gartner supports a similar concept, which they call Secure Access Service Edge or SASE. Fortinet is an industry leader in building, integrating and automating security products and services into Fortinet Security Fabric, including FortiSASE. With the recent acquisition of OPAQ Networks, Fortinet has enhanced its FortiSASE solution with expanded cloud delivery, including firewall as a service and Zero-Trust Network Access. Additionally, FortiSASE was built to be partner-friendly, empowering MSPs and major global customers to integrate or build the FortiSASE platform into their own offerings. A critical component of Fortinet Security Fabric platform is SD-WAN. We recently announced the new FortiGate 80F, which expands our SD-WAN portfolio for branch offices and work-from-home setups. The FortiGate 80F is powered by the latest FortiSPU SoC4, which can deliver Security Compute Ratings as much as 25 times higher than industry average appliances using generic CPUs. According to Gartner, worldwide SD-WAN equipment market data for the first quarter of 2020 indicates that Fortinet has the highest revenue growth and ranks among the top 3 for market share. We attribute this growth to our ability to deliver secure, high-performance SD-WAN solutions anywhere from home to the branch to the cloud. Security investment remains a priority for enterprises and service providers, as demonstrated by the strong growth of our high-end FortiGate appliance during the last quarter. Today, we released the FortiGate 4400F, the only firewall in the industry capable of securing hyperscale data centers and 5G networks. Powered by the NP7 network processor, the 4400F delivers the highest performance with a Security Compute Rating of up to 13 times higher than our competition. The release of several new appliances powered by our latest FortiASIC SPUs, along with cloud and software-based virtual machines to deploy security anywhere, allows Fortinet to capitalize on this investment and places us in a strong position going forward. Before turning the call over to Keith for a closer look at our second quarter performance and our guidance, I would like to take a moment to welcome the over 400 people who joined Fortinet during the second quarter, as well as the OPAQ team who recently joined. I also want to thank our employees, customers, and partners worldwide for their continued support in managing our response to the ongoing COVID-19 pandemic.

Thank you, Ken. Let's start the second quarter review with revenue. Total revenue of $616 million was up 18%, driven by non-FortiGate products and service revenue growth of 25%. Non-FortiGate revenue growth benefited from very strong demand for virtual machines and our work-from-home solutions. FortiGate product and service revenue growth was 16% and benefited from record levels of billings for our secure SD-WAN solution. To a large extent, our second quarter revenue growth, together with the backdrop of the COVID-19 pandemic, affirms the benefits of our diversification across geographies, customer segments, and industry verticals. At the same time, it illustrates the level of revenue predictability in our business model. Our continued growth in this environment is a result of our strategic internal investments made to expand our global sales force, invest in our channel partners, and extend our cost performance advantage as we update our product offerings and penetrate adjacent security markets. Product revenue grew 12% to $212 million, benefiting from strong demand for secure SD-WAN, high-end FortiGates, and FortiGate virtual machines. Our work-from-home solutions continue to provide a tailwind to growth. Our growth rates and industry reports suggest we continue to take market share in both the firewall and SD-WAN markets, where we have demonstrated leadership and innovation. Moving to service revenue, service revenue grew 22% to $404 million, representing 66% of total revenue. Over 90% of service revenue was from deferred revenue at the beginning of the quarter and continues to support our revenue growth and predictability. FortiGuard security subscriptions revenue increased 22% to $223 million. FortiCare technical support revenue increased 22% to $181 million. The revenue mix shift from 8/5 support to our higher-priced 24/7 support was 9 points, with 24/7 support now representing 64% of the mix. Let’s shift to billings. Total billings increased 14% to $711 million. Total billing growth was negatively impacted by approximately 2 points by training and professional services and other miscellaneous products, which are not classified as FortiGate, fabric or cloud. Earlier this year, we announced our decision to make our network security expert (NSE) online training and certification program free to the public. While this decision resulted in reduced training billings and training revenue, we're very excited about the demand we are seeing with our NSE training. As of this week, the number of NSE registrations for 2020 exceeded 500,000, and the number of NSE certifications issued increased over 200% to nearly 200,000. Looking at billings by product segment, FortiGate billings increased 14% and accounted for 73% of total billings. FortiGate billings include our secure SD-WAN solutions. As Ken mentioned earlier, SD-WAN surpassed the 10% threshold for the first time ever, representing 12% of total billings. Non-FortiGate billings also increased 14%, driven by strong demand from our virtual and work-from-home solutions, albeit offset by smaller contributions from switches and access points. I would also note the decline in billings for professional services, training, and other miscellaneous products. Our geographic performance aligned with the trajectory of the pandemic and highlighted the geographic diversification of our business. APAC outperformed all geographies, followed by Europe, while North America faced more challenges. Our North America results include the United States, where we observed headwinds from the education and local government sectors, where the COVID-19 pandemic remains an issue. In contrast, the retail segment was by far the strongest-performing U.S. vertical with growth of over 40%, driven by the ongoing expansion of the SD-WAN solution. The U.S. SMB segment showed robust growth as well, which illustrates the strength of our U.S. channel programs and the solid execution by our channel partners and the Fortinet team. Looking across the Americas, our analysis indicates that certain transactions were deferred into the second half of this year as companies focused on their capital structure and immediate priorities. In terms of worldwide billings by industry verticals, the diversification of our business model was again evident, with our top 5 verticals accounting for about two-thirds of total billings. The worldwide government sector led all verticals with 19% of total billings. Service providers and MSSPs accounted for 15% of total billings. Financial services comprised 14% of total billings and had a strong quarter with billing growth of 33%. Despite COVID-related concerns, the retail vertical posted 27% growth in worldwide billings, representing 10% of total billings, benefitting from SD-WAN and strong U.S. performance previously mentioned. We saw strong growth in retail sub-verticals such as drugstores, groceries, and portions of the wholesale sector. At the end of the second quarter, total deferred revenue increased 24% to $2.3 billion, with short-term deferred revenue also increasing 24% to $1.3 billion. Now, let's discuss deals by size. The number of deals over $1 million grew 28% to 59, with secure SD-WAN accounting for 13 of these deals. This performance illustrates our continued capacity to move upmarket into the enterprise segment and indicates the robust acceptance of our differentiated secure SD-WAN offering. Moving back to the income statement, gross margin improved 260 basis points to 79%. Product gross margin improved 340 basis points to 61%, driven by the lower cost structure of our newer generation of FortiGate products and over 40% growth in software products. Services gross margin increased 120 basis points to 88.5%, reflecting the 24/7 support revenue mix shift. Our operating margin for the second quarter increased 370 basis points to 27.3%, benefiting from improved gross margin as well as lower travel and marketing expenses due to the shift to virtual events. Our total headcount at the close of the quarter was 7,756, an increase of 23%, driven by higher investments aimed at growing our business while reflecting a decline in sales and attrition rates. Given our continuous growth, strong operating margins, and free cash flow, we do not anticipate any COVID-19-related layoffs in the foreseeable future. In fact, we plan to capitalize on our many opportunities by continuing to hire and invest in our balanced growth strategy. Overall, net income for the second quarter was $135 million, resulting in earnings per diluted share of $0.82. On a GAAP basis, we reported net income of $112 million or $0.68 per diluted share compared to GAAP income of $73 million or $0.42 per diluted share a year ago. Looking at our cash flow statement, free cash flow increased by 21.5% to $216 million. The average contract term in the second quarter remained consistent with our expectations, declining by one month year-over-year to 26 months while moving up one month sequentially. We anticipate leveraging the strength of our balance sheet as a competitive advantage to support our partners and customers. Average contractual payment terms increased to 62 days, up 17%, which reflects our decision to offer extended payment plans based on geographical needs. Capital expenditures for the second quarter were approximately $31 million, inclusive of $21 million related to construction and real estate activities. For the third quarter, we estimate capital expenditures to be between $50 million and $60 million and project a full-year estimate of $165 million to $185 million for 2020. Delays in the new campus construction pushed part of our expected 2020 CapEx into the first half of 2021. We expect full-year cash taxes to be around $40 million, with our full-year non-GAAP tax rate at 22%. In the second quarter, we repurchased around 1.4 million shares of common stock, totaling approximately $146 million. In July, the Board authorized an additional $500 million for our share repurchase program and extended the term to February 2022, leaving us with around $1 billion in remaining share buyback authorization. Lastly, we wanted to share additional thoughts regarding the ongoing COVID-19 pandemic. We have and intend to leverage the strength of our balance sheet, which may lead to increased DSOs and inventory levels. The economic impact of the pandemic appears to correspond with the ability of different countries and regions to reopen effectively and avoid temporary shutdowns and uncertainty. For instance, after robust growth in billings in April, we noticed a slowdown in May, with a rebound back to strong growth in June and July. Concurrently, the remaining Q3 pipeline indicates a good level of improvement, both in the U.S. and globally. In the second quarter, our channel partners noted that some deals were pushed into the latter half of the year, suggesting that these opportunities remain and are not lost based on our pipeline growth and July's sales activity. Clearly, there is a sustained level of uncertainty about future pandemic events and economic conditions.

I think SD-WAN provides a long-term benefit for both enterprise and SMB segments by reducing the cost of connecting to the Internet while improving efficiency. For us, our approach combines security with ASIC technology, which provides a significant advantage over our competitors. The market grew approximately 50% year-over-year, indicating robust potential and pipeline. We are confident in gaining market share due to our unique solutions and significant sales capacity growth, despite some delays during the pandemic, as we continue to add new employees. We anticipate realizing our pipeline opportunities. We regard the FortiSASE as a fundamental part of the entire infrastructure. Our OPAQ acquisition enhances existing cloud delivery solutions and provides greater flexibility to customers and partners.

Maybe a bigger picture question for you. The combination of SD-WAN adoption in a more durable work-from-home environment may leave investors with the assumption that traditional enterprise branch offices are at risk, either from a refreshed footprint perspective or from cannibalization. Could you help separate the potential impacts on your branch office footprint?

We have seen some slowdown in enterprise branches, particularly in the U.S., but we see strong growth in our products from both new and existing customers. Our newer products, characterized by high performance figures, particularly benefit the SMB segment in the U.S., with notable year-over-year growth. Many organizations, particularly internationally, were slower to adopt newer products, but we expect strong growth as evaluations and sales processes progress.

In relation to billings performance, we feel good about the SD-WAN opportunity. While we encountered some pauses regarding new projects due to the pandemic, we are optimistic about our pipeline and upcoming sales prospects, as indicated by recent trends in July.

Regarding the SD-WAN and secure SD-WAN dynamics, we have seen strong demand across multiple sectors, and our product launches position us well to accommodate both traditional and cloud-based security requirements.

I'm interested in the dynamics of large deal performance and any impact this may have on billings, particularly within the U.S. financial services sector where some weakness was reported.

The strength in financial services we observed came primarily from outside the U.S. While the pandemic did impact the Northeast region, which houses a considerable component of this sector, our diversified business elsewhere mitigated potential losses.

Could you provide insights into deals that got pushed into the September quarter and how that might affect performance?

Some sizable deals indeed shifted into Q3, particularly concerning the U.S., but we anticipate seeing our sales activity increase and deal closures following this period of adjustment.

SD-WAN and secure SD-WAN initiatives are reinforcing our competitive edge and driving strong growth in sectors such as retail, especially through digital transformation efforts.

Thank you, Chris. I'd like to thank everyone for joining today's call. Fortinet will be attending the following virtual investor conferences during the third quarter. We'll be doing the Oppenheimer conference next week on August 11; the Citibank conference on September 9; and the Colliers Securities conference on September 10. Event presentations will be webcast, and links will be available on the Investor Relations website. If there are any follow-up questions, please feel free to contact me. Have a great rest of your day. Thank you very much. Take care. Bye-bye.