Fortinet, Inc. Q4 FY2020 Earnings Call

Ladies and gentlemen, thank you for standing by. And welcome to the Fortinet Fourth Quarter 2020 Earnings Announcement. At this time, all participant lines are in a listen-only mode. After the speakers’ presentation, there will be a question-and-answer session. Please be advised that today’s conference is being recorded. I would now like to hand the conference over to your host today, Peter Salkowski, Vice President of Investor Relations. Please go ahead.

Thank you, Sarah. Good afternoon, everyone. This is Peter Salkowski, Vice President of Investor Relations at Fortinet. I’m pleased to welcome everyone to our call to discuss Fortinet’s fiscal results for the fourth quarter of 2020. Speakers on today’s call are Ken Xie, Fortinet’s Founder, Chairman, and CEO; and Keith Jensen, our CFO. 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 fourth quarter, providing guidance for the first quarter of 2021 and the full year. We’ll then open the call for questions. During the Q&A session, we ask that you please keep your questions brief and limit yourself to one question and one follow-up question to allow others to participate. 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 stated otherwise. Our GAAP results and GAAP to non-GAAP reconciliations are located in our earnings press release and in the presentation that accompanies today’s remarks, both of which are posted on the Investor Relations website. Lastly, all references to growth are on a year-over-year basis unless noted otherwise. I will now turn the call over to Ken.

Thanks, Peter, and thank you to everyone for joining today’s call to review our fourth quarter and full year 2020 results. Fourth quarter billing increased 20% to $961 million. Our secure SD-WAN offering accounted for over 13% of fourth quarter billing. Product revenue accelerated quarter-over-quarter to 21%, contributing to a total revenue growth of 21%. Operating margin benefited from solid revenue performance. We achieved an all-time company record non-GAAP operating margin of 29.4% for the fourth quarter. Given the many opportunities ahead, we plan to shift our focus more to growth for at least the next few quarters. Today, we announced the FortiOS 7.0 with 300 new features and updates. With this release, Fortinet is the only leading cybersecurity vendor to offer firewall-based zero trust network access, enabling remote access to replace the traditional VPN. This reduces attack surface while improving user experience. Fortinet’s Zero Trust Network Access solution also simplifies management by using the same access policy, whether on or off network. Tighter integration of a SASE solution with FortiOS 7.0 gives enterprises the flexibility they need to enable their workforce to work from home with consistent, enterprise-grade security delivered on-premise or now, via cloud-based SASE consumption for security-as-a-service. The FortiOS 7.0 extends network connectivity and security beyond the WAN Edge with innovations in 5G and LTE that improve wireless network performance and increase resiliency. Our 5G offering enables organizations to achieve secure, scalable and highly available network connectivity anywhere. The release of FortiOS 7.0 expands the Fortinet Security Fabric, delivering on our mission to provide broad, integrated and automated security to any device, any application everywhere. Cybersecurity is at an inflection point, and increasingly, organizations are consolidating towards a platform approach and not just a separate platform for endpoint, network security or cloud security but a holistic platform that is integrated, automated across all these areas. The Fortinet Security Fabric is a cybersecurity platform built on a broad and deep set of networking security technology from endpoint to network to cloud, organically built to seamlessly communicate and operate together. This consolidation with our security-driven networking approach will be key drivers going forward. Today, Fortinet is recognized in the 8th Gartner Magic Quadrant. Our FortiGate product is a leader in both the SD-WAN and the Next Generation Firewall Magic Quadrant. We continue to experience excellent adoption of our secure SD-WAN and expect our unique solution to become a market share leader within a few years. In addition, for our growth drivers, we estimate our total addressable market will grow at an annual compound rate of 10% over the next four years to reach $93 billion by 2024. The recent security incidents and the pandemic elevated the need for a broad, integrated and automated platform. And we expect companies will raise the percentage of IT spending used for security as they work to secure their entire infrastructure across multiple edges in a zero trust environment. Before turning the call over to Keith, I would like to thank our employees, customers, and partners worldwide for their continuous support to manage our response to the ongoing pandemic.

Thank you, Ken. Let’s start the fourth quarter review with revenue. Total revenue of $748 million was up 21%. Product revenue was up 21%. Service revenue was up 21%. Product revenue of $288 million saw substantial sequential acceleration in growth relating to strong demand for our Security Fabric Platform and FortiGate across all form factors, hardware, software, and virtual machine. While secure SD-WAN use cases continued their dramatic growth, the majority of product revenue was driven by the wide range of other operating system capabilities embedded in FortiGates and their related use cases. Service revenue of $460 million benefited from strong demand for fabric and cloud security solutions. Support and professional services revenue increased 21% to $210 million. The revenue mix shift from 8x5 to 24x7 support was 12 points, with 24x7 now representing 66% of the mix. Security subscription services and cloud provider revenue increased 21% to $249 million. Moving to the mix of FortiGate and non-FortiGate revenue. Network security revenue increased 18%, driven by the high end and entry-level FortiGate product families. Non-FortiGate products and service revenue increased 29%, driven by a 34% increase in revenue for fabric and cloud security solutions. Before continuing with the fourth quarter results, I’d like to highlight our 2020 full-year revenue performance. In the midst of a pandemic-induced recession, total revenue for the year grew 20% to $2.6 billion. We take great pride in our focus on organic growth, and 2020 represents the third consecutive year with revenue growth of 20%. This consistent performance speaks to our geographic and customer diversity, the continued success of the integrated platform strategy, and our proprietary ASIC advantage that enables a shared operating system across the platform, driving our cost-per-performance advantage and increasing capacity to add features and functions while maintaining price points. Total non-FortiGate revenue for the year grew over 25% to more than $725 million. In other words, our fabric, cloud and other security products and services are on pace to be a $1 billion business as we exit 2021. Our non-FortiGate and FortiGate products and solutions include a complete range of form factors and delivery methods, including physical and virtual appliances, cloud, SaaS, and perpetual software, as well as hosted and non-hosted solutions. Together, they provide a range of security solutions and form factors, enabling integrated protection for hybrid environments and their expanding digital attack surface and edges. Pivoting back to our Q4 results, let’s turn to revenue by geo. Our geographic revenue performance continued to align with the pandemic’s economic path, and with it highlighted the geographic diversification of our business. Revenue in Asia Pacific increased 23% as many Asian countries and economies continue to remain largely open. EMEA revenue increased 22%, and the Americas posted revenue growth of 20%. Let’s shift to billings. Total fourth quarter billings were $961 million, up 20%. FortiGate billings increased 16% and accounted for 71% of total billings. Non-FortiGate billings increased 29% of total billings, driven by demand for fabric and cloud security solutions. As with revenue, geo billings performance aligns with the economic path of the pandemic. In terms of growth, APAC billings outperformed all geos, followed by Europe and the Americas. Moving to billings by customer segments, the small enterprise segment posted solid growth across all geos, illustrating the strength of our Engage channel partner program. This segment is driven by new customer acquisitions, customer security fabric expansions, solid execution by our channel partners and the large diverse makeup of this multinational customer segment. Moving to worldwide billings by industry verticals, the worldwide government sector topped all verticals at 17% of total billings and grew 28% with another strong performance from our international team. Service providers and MSSPs accounted for 16% of total billings. Retail accounted for 10% of total billings, up 2 percentage points quarter-over-quarter, and Education continued to rebound with billings growth up 26% year-over-year. Looking now at deals by dollar size, we had 68 deals over $1 million in the fourth quarter compared to 64 deals in the fourth quarter of 2019. Secure SD-WAN accounted for 16 deals over $1 million, versus 11 deals in the fourth quarter of 2019. On a full-year basis, SD-WAN accounted for approximately 11% of our total billings and doubled year-over-year. Moving back to the income statement, gross margin improved 40 basis points to 78.5%. The strong 29% quarter-over-quarter product revenue growth created a mix shift from services to product revenue. The mix shift was a headwind for quarter-over-quarter gross margin comparisons. Product gross margin improved 130 basis points to 63.2%. Product gross margin continued to benefit from a higher mix of software products and the lower direct cost of our newer generation of FortiGate products. Operating margin for the fourth quarter increased 210 basis points to 29.4%, benefiting from the gross margin improvement and continued lower travel and marketing program expenses, offset by the addition of new sales team members as we continue to prepare for additional growth. At the end of the year, the total headcount was 8,238, an increase of 16%. Moving to the statement of cash flow, cash flow for the fourth quarter came in at $264 million. In the fourth quarter, we repurchased approximately 300,000 shares of our common stock for a total cost of $34 million. For the full year, we repurchased 11.7 million shares for a total cost of $1.1 billion. At the end of the fourth quarter, the remaining share repurchase authorization was $1 billion with the authorization set to expire at the end of February in 2022. Throughout the pandemic, we have leveraged the strength of our balance sheet as a competitive advantage to support our partners and customers as they experience geo-specific economic challenges. As a result, average days sales outstanding increased 8 days to 87 days, in line with our expectations and reflecting our decision to provide geographically targeted extended payment plans. Inventory turns improved to 2.7 times from 2.1 times in the third quarter and was relatively flat year-over-year. We expect extended payment terms and higher inventory balances to be in effect as we move through at least the first half of 2021. Capital expenditures for the fourth quarter were $32 million, including $22 million related to construction and other real estate activity. We estimate capital expenditures for the first quarter between $50 million and $60 million, and for all of 2021 to be between $150 million and $170 million. 2021 CapEx projects include expanding our data center footprint and spending that was moved from 2020 due to delays in the new campus building. The average contract term in the fourth quarter was approximately 28 months, up less than 2 months from the fourth quarter of 2019. The growth in SD-WAN and other large enterprise deals contributed to the increase. As we look forward, I’d like to review our outlook for the first quarter and full-year 2021, which is subject to disclaimers regarding forward-looking information that Peter provided at the beginning of the call. For the first quarter, we expect billings in the range of $765 million to $780 million; revenue in the range of $670 million to $685 million; non-GAAP gross margin of 78.5% to 79.5%; and non-GAAP operating margin of 22.5% to 23.5%, reflecting the typical revenue seasonality associated with the first quarter; non-GAAP earnings per share of $0.70 to $0.75, which assumes a share count of between 167 million and 169 million. We expect the non-GAAP tax rate of 21%. Before providing our 2021 guidance, I’d like to congratulate every member of the Fortinet team for the truly outstanding execution in 2020 in the face of unprecedented challenges and rapidly changing and unpredictable dynamics. The effort and results have been outstanding. And this is on top of now several years of consistent, predictable performance, and continuing improvements in key growth and profitability metrics. Today, we reported our third consecutive year of total revenue growth of 20%, while increasing our non-GAAP operating margin, an average of over 200 basis points a year for the same period. Our goal remains to balance growth and profitability within the framework we have provided. As Ken mentioned, given the many growth opportunities that lie ahead, we currently plan to tilt our bias within this framework more towards growth for at least the next several quarters. The opportunities we see are supported by a strong pipeline heading into 2021, increased sales capacity and our development efforts, which include the NP7 chip and our new FortiOS 7.0 operating system. With that, for 2021, we expect billings in the range of $3,560 million to $3,640 million, which at the midpoint represents growth of approximately 17%; revenue in the range of $3,025 million to $3,075 million, which at the midpoint represents growth of 18%; total service revenue in the range of $2,015 million to $2,045 million, which represents growth of approximately 21% and implies product revenue growth of approximately 11%. We expect our non-GAAP gross margin of 78% to 80%; non-GAAP operating margin of 25% to 27%. Non-GAAP earnings per share of $3.60 to $3.75, which assumes a share count of between 170 million to 172 million. We expect our non-GAAP tax rate to be 21%. We expect cash taxes to be approximately $80 million. Now, with Ken, I’d like to thank our partners, customers and the Fortinet team for all their support and hard work during these difficult and unique times. I’d also like to offer a special welcome to the Panopta team. And I’ll now hand the call back over to Peter to begin the Q&A session.

Thank you, Keith. Operator, please open the call for questions.

Thank you. Our first question comes from the line of Brian Essex with Goldman Sachs.

Hi. Good afternoon. Thank you for taking the question. And congrats on a great set of results. Maybe, Ken, if I could ask, you’ve got a number of different product cycles ahead of you this year. You’ve got NP7. You’ve already talked about SD-WAN. You’ve got hyperscale penetration and potential exposure to 5G. Can you maybe talk about the contribution from each of those that’s embedded in your guidance? And, what are you seeing currently in the market, and what’s yet to come?

I think for NP7, it’s still in the ramp-up stage. We continue to build a new platform using NP7, it’s better for the high end and middle range. The FortiOS 7.0 is also a growth driver, but we are in the beta-3 process right now this quarter. That’s what’s helping contribute to the additional growth, especially in the zero trust and SASE environment and also in infrastructure security later this year. So far, I see the product growth, like 21% is a lot of contribution from whether the SD-WAN or we call it security-driven networking and also in the probably like 1 to 2 years ago, when we released the SoC4. So, that’s a little bit towards the low end side of the FortiGate, which you can see nicely grows over there. And also the team is doing a great job in the sales and marketing.

Yes. I believe the guidance process focuses less on specific products or individual use cases. We have identified 15 to 20 different use cases for firewalls. It is more centered on the market opportunities and the pipeline rather than geography or deal opportunities as key factors. However, I want to clarify that the guidance we provided is not reliant on factors like 5G or SASE or any other external considerations.

Got it. That’s helpful. Maybe just a quick follow-up. Nice large deal activity, certainly more than we picked up in the channel. Maybe if you could talk a little bit about the competitive dynamics on the large end of your market scale. Where you’re seeing that business come from? How much is displacement, and how much is expansion of, I guess, existing customer opportunity?

Yes, definitely. Our customers and partners are increasingly finding our Fortinet products to be superior and more competitive. The FortiGate benefits from the new ASIC and operating system, which offer many additional features compared to our competitors, creating a greater advantage for us. This is driving an acceleration in product revenue growth. We also take a different approach with SASE and cloud endpoints, focusing on integration and automation, especially at the OS level, which sets us apart from our competitors. Most of our solutions have been developed internally and designed to work and automate seamlessly from the start. Therefore, we believe we have a significant advantage in the marketplace right now.

Our next question comes from the line of Shaul Eyal with Oppenheimer.

Congrats on the ongoing strong execution levels. I want to start with a gross margin related question. So, gross margins guidance for 2021 indicates an improvement, 1 to 2 basis points on average. And I’d like to understand whether it is driven by the ongoing shift to more cloud activities, i.e., more subscription services, or is it driven by some improvement with your ASIC-driven strategy?

Yes. I think, the last part is probably the headline, which is that each successive generation of the ASIC in addition to creating more speed, more capacity, if you will, more throughput. It also creates capacity to consolidate features of the BOM that were previously separate. And the success of the generation has shown the benefit of that. I think over the last year or two, we’ve done a very good job of retaining that cost benefit in terms of the structure. You can look back and see what’s happened with the gross margin, on the product gross margin line. Obviously, you do then also get the benefit in total when you add into two-thirds of the business that are services that are coming at a much more attractive margin. So, the combination of those two, I think, is working very, very well for us as we exit 2020 and move into 2021.

And maybe high level on the Sunburst breach. Have you seen any incremental interest starting in mid-December, maybe building into year-end, again, just aside from the typical healthy year and seasonality trend?

I’d say we see a lot of interest in securing the entire infrastructure, including the supply chain with various third-party products. There are definitely more people interested in this area, but the business side hasn't changed much yet. However, we anticipate that later this year, due to growing security concerns, security spending will likely continue to increase within our overall IT budget.

Our next question comes from the line of Tal Liani with Bank of America.

I have two questions. The first one is, Ken, in your prepared remarks, you said that this year is going to be a year of focus on growth. What does it mean? Does it mean that you’re going to increase expenses and the margin increases will moderate? Can you elaborate on the meaning behind your statement that you’re going to now focus on growth this year? And how does it differ from the previous year, for example?

We have noticed the impact of our investments in sales and marketing, which have led to an increase in sales capacity and better visibility. We have also enhanced our marketing efforts. On the product and infrastructure front, we will continue to invest, particularly in organic internal development, such as building new infrastructure for cloud services and networking endpoints and collaborating with service providers. The market is starting to pick up, especially in emerging areas like security-driven networking, which includes both SD-WAN and 5G. This new infrastructure will also support various service models that we plan to further invest in. We believe this approach will provide significant growth opportunities. Internally, products like NP7 and FortiOS 7.0 are timed well to help accelerate our growth.

Yes, Tal, I want to add to that. We had a lot of success throughout 2020, even during the pandemic, by maintaining and significantly increasing our operating margins while also expanding our sales capacity. When we started to create our guidance and plan for 2021, given our current capacity, along with the rise in tenure and the pipeline, we feel optimistic about our ability to seize growth opportunities. We believe the margin guidance, at the midpoint of 26%, fits well within our expectations and is actually slightly higher.

Got it. My second question is about the needed investment in infrastructure to accommodate SASE and similar business models. What is the company doing in order to address it? Can you just elaborate on what’s happening behind the scenes?

The SASE approach for Fortinet stands apart from some competitors. We aim for a more integrated and automated solution. We are unique at the OS level, offering both SASE and zero trust network access. This allows us to collaborate with service providers and customer enterprises to create tailored SASE solutions that better align with their privacy needs, such as GDP or other requirements. Our approach is more secure compared to alternatives. We are making some investments, particularly in infrastructure, while also collaborating with our service providers.

Our next question comes from the line of Rob Owens with Piper Sandler.

Hi, this is Ben Schmidt filling in for Rob. Thank you for taking my questions. As the focus in the industry shifts towards cloud and SASE, how do you view your long-term strategy regarding remote connectivity? What are your expectations for branch offices?

I believe our technology can accommodate both thin and thick branch office strategies. We provide flexibility for enterprises regarding SASE, allowing them to choose whether to work with a vendor, utilize a service provider or carrier, or develop their own solutions. Our OS-level integration is more advanced and automated compared to other approaches that rely on vendor infrastructure. This OS-level integration of SASE offers significant flexibility and a gradual transition for customers, whether they prefer service-based solutions or a traditional security infrastructure approach. Although it might take more time to develop this highly integrated OS-level approach, the end result is superior and more sophisticated than other less cohesive methods.

Okay. And on the growth investment, can you guys add just a little bit more to how much of the capacity has already been added? And how much you’re expecting to add, I guess, how much more needs to be added for this year? And can you remind us what the normal ramp time period is for new reps?

For new representatives, the ramp-up time may vary by vertical, with channels typically taking around three months and enterprise roles requiring six to twelve months. Generally, it can take one to two years. We will also adjust based on pandemic developments and market opportunities. We intend to increase our capacity as new opportunities arise and align our investments with the internal new products and market prospects, which will definitely support our continued growth in SASE.

Our next question comes from the line of Fatima Boolani with UBS.

Ken, maybe I’ll start with you. Just drilling into your vertical-based performance, you talked about the global government vertical comprising a fifth of your billings in the quarter, and that’s some of the highest levels we’ve seen. I’m wondering if you can remind us what your U.S. public sector exposure is within that government exposure? And then, more specifically, how is Fortinet positioned, both from a product and go-to-market perspective in the U.S. federal, especially as we sort of think about the $10 billion cybersecurity spending protocol from the new Biden administration?

Yes. The government business for Fortinet’s global base is about 17% of our total business for us right now. Compared to a few years ago, the carrier service provider is the number one at over 20%. Now they are around 16%. For the U.S. government, we still see a lot of opportunity and the same thing for the U.S. market. We’re going to keep building the team and increase capacity to take this opportunity and grow faster and larger.

I think we've mentioned before that the U.S. government's share is a small percentage of our overall business.

Got you. Very helpful. Keith, just sticking to Americas, we saw a very nice acceleration in Q4 in the Americas theater, and against what was maybe an uneven geographical performance for the U.S. over the course of 2020. I’m wondering if you can just put a finer point on the types of things that went right and the types of things that really went on in the quarter, and the key drivers of the strength, particularly in the Americas. That’s it for me.

Yes, that's a good question with various answers. Geographically, Latin America remains the most challenged region. Canada likely performed the best among the three, while I would place the U.S. in the middle. We're very pleased with the U.S. recovery. Looking at the second quarter, we have gained insights from our experiences during the pandemic and analyzed the expectations for each quarter. It's clear that the second quarter was a low point for the company overall, and specifically for the U.S. Since then, we've observed a consistent recovery in that sector of the business.

Our next question comes from the line of Brad Zelnick with Credit Suisse.

Thank you so much. And congratulations to the entire Fortinet team on a great end to a great year. My first question for you, Ken, in your comments, you basically said that you aspire to be the market share leader in SD-WAN, which I think is a really important goal that you have. I’m just curious, from your perspective, what needs to happen to get there? How do you take share from your two largest competitors that have significant installed base relationships? Over what time can this play out?

I think, for us, we have a unique advantage of we build SD-WAN with security together, and we also leverage ASIC to increase computing power, lowering competition costs. None of our competitors have that kind of capability. The other two big leaders, they come from acquisitions, where going forward, they probably will be slower on whether the innovation of the market change dynamic there. You can see from the FortiOS 7.0 release, we did see the increased additional functions, whether the SD-WAN, 5G and other parts. We believe, going forward, like half or majority of the SD-WAN market will need security. So, we have a huge advantage there. Even if they have a larger installation base, the advantages we have from the product, from a function and from the cost side, I think will be huge. So far, like year-over-year, we almost doubled the SD-WAN business compared to 2019 in 2020.

Great. And maybe just quickly for Keith. Keith, what are the levers to think about, in light of sales headcount, and the plans for this year?

Brad, I’m not quite sure I fully understand the question, but maybe I’ll give it a shot and share one data point of coming into this year. If I look at the level of sales capacity we have versus what the plan is, we’re in a very good position to pivot towards this growth model that Ken has talked about. The pipeline feels very good. The tenure feels very good. The use cases, the TAM feels very, very good to us. The new FortiOS, the NP7 shift is coming out, the platform advantage, the cost advantage that we have for performance. I think we are in a very good position to execute this. We’re maintaining it within the framework that we’ve talked about previously.

Our next question comes from the line of Sterling Auty with JP Morgan.

Just one question from my side. Ken, in your prepared remarks, I think you talked about that the industry is finally raised, the customers move to consolidation on fewer vendors, more of a broad platform approach. With that in mind, where would you gauge the Fortinet platform and what are the areas that you would like to bolster to improve your position moving forward?

You can see that the security fabric has experienced significant growth, nearly double that of FortiGate. This is partly because customers are looking for a fully integrated, automated security infrastructure. We are continuing to gain market share in this area, which encompasses around 20 to 30 different products. On the FortiGate side, we are focused on security-driven networking, including SD-WAN, 5G, and integrated SASE, while collaborating closely with service providers. This presents many opportunities for us. If the market grows around 10%, we believe we can grow at a much faster rate and continue to capture market share in both FortiGate and our broader fabric approach, which integrates endpoint, networking, and cloud solutions. All of this works together based on FortiOS and related connectivity features.

Our next question comes from the line of Adam Tindle with Raymond James.

Ken, I just wanted to start on the focus more on growth comment and how you’re investing some of your healthy margin and some sales and marketing initiatives. We also heard a similar message from a competitor yesterday. Just thinking about the broader industry implications of that, an outsider could maybe make the case that we enter a period of greater industry competition and pricing pressure as major competitors are investing heavily in sales and marketing. Certainly, doesn’t seem to be the case based on your full-year margin guide. So, maybe some thoughts on why that scenario does not play out?

Ken, may I step in to respond? The reference seems to be about a company with a completely different business model. Whether we consider growth rates or product service offerings, I don't think you can draw a direct comparison. Our business model has proven to be very successful, and I believe it will continue to thrive. Regarding discounting, there are times when I prefer not to accept it, but we are recognized as the leader in price for performance. Our pricing often sets the benchmark for competitors, who find themselves reacting to us. Reflecting on our comments from 2020, even during the pandemic, discounting has generally been beneficial for us rather than a drawback. I view discounting as a lower pressure on discounts in a given quarter compared to the previous one. Hence, I don't believe we face the concerns that have been mentioned.

Okay. That’s helpful. And maybe just a quick follow-up, Keith. The billings guidance for Q1, it’s down about 20% sequentially at the midpoint and typically down low double digits or so, mid-teens in that range. Last year, at the start of COVID, it was down 17%. Part of the question is, why would the sequential decline in billings be worse than the environment when we entered COVID during Q1 of last year? You talked about having a strong pipeline supporting the desire to invest. Maybe just some help with the color on the disconnect between those two items. Thank you.

Yes. I believe one factor we're discussing is the outstanding performance in the fourth quarter of 2020. While Q4 2019 was also strong, Q4 2020 built on that performance. Typically, this quarter is the smallest for us each year. Historically, we have seen some transition from Q4 to Q1, and then the progression becomes evident afterward.

Our next question comes from the line of Keith Bachman with Bank of Montreal.

Ken, I wanted to start by asking you about 5G. Why do you see it as an opportunity? Who are your customers? What makes Fortinet successful in the deployment of 5G? Additionally, could you share when you expect to see the benefits from this?

I think we do see 5G connect a lot of devices to the Internet, which also increases a lot of security risk. We call there’s a new attack service, a new edge need to be covered. That’s where especially, we’re working with a lot of service providers for the 5G service to many enterprises and connect all these different devices in the OT/IoT space. We see a huge opportunity. Our position with the carrier service provider will play an important role. We do see that 5G can be one of the driving growth factors for us this year, and it could be material towards the end of the year. Going forward, it’s also a huge opportunity, even securing the whole infrastructure, which grows very, very fast and a lot of our carrier service providers starting to have investment in this area also.

Okay, interesting. Okay. And then, Keith, one for you. For the guidance of 2021, you talked about CapEx. Any other puts and takes you want us to think about as it relates to OCF or operating cash flow?

No, not really. I mean, I made the point about inventory. The turns came in for us pretty strong in the fourth quarter, but I think that’s a direct reflection of the success that we had in the product revenue line in the fourth quarter. So that was probably a little bit better than we expected. I do think during this pandemic era that we’ll continue to maintain somewhat higher levels of inventory. I think that’s in our best interest. The extended payment term program, I think that every CFO wants to wind that down as fast as possible and every distributor wants to hold on to it for life. So, that will be an ongoing battle for us throughout 2021, I think.

Our next question comes from the line of Ben Bollin with Cleveland Research.

My first question, you’ve made your aspirations pretty clear in SD-WAN. Could you share with us a little bit about aspirations, intentions as you move into SASE and zero trust, how you see yourself positioned?

Yes, SD-WAN is a component of our SASE offering. Our approach differs from that of our competitors. We integrate it within the FortiGate and FortiOS, which can be deployed through physical hardware, virtual software, or cloud solutions. The new FortiOS 7.0 provides significant flexibility and connects various elements of infrastructure and security services. We expect SD-WAN to continue growing substantially, likely at a rate of 30% to 40% year-over-year this year. We believe we are also increasing our market share. Additionally, with the emergence of 5G, we have introduced opportunities in the new FortiOS 7.0, which could drive further growth.

Could you also talk a little bit about how you envision FortiOS 7 rolling out, once available? How backwards compatible will it be for legacy appliances? And if you’ve looked at some of the historical OS refreshes, how long does it take the footprint to roll over, as this rolls through the base? Thank you.

It really depends on the customer. The channel tends to react a bit faster, while enterprise and service providers may take a little longer due to their support requirements. However, we see this as an opportunity to create new offerings. The tightly integrated approach, including SD-WAN and SASE, which we refer to as security-driven networking, allows them to offer additional services and protect more edges. It is essential to protect all edges collectively and automate the integration rather than using different products and vendors for each component, which complicates the integration process. Our response to the 300 new features and updates in this OS spans a broad area. Customers need some time to gradually adapt and learn the new functions, but many recognize the significant advantages, which presents a substantial opportunity for us. We expect to see considerable benefits, especially in the second half of the year.

Our next question comes from the line of Michael Turits with KeyBanc Capital Markets. Your line is open.

Hi. This is Eric Heath on for Michael. Just one for me. Keith, it seemed like you guided billings for Q4, assuming some macro headwinds. How did that play out differently than you expected, especially on the product side? Did you see deferrals of hardware refreshes in 2020 that might snap back in 2021?

Yes, we have a very extensive product lineup. I don't believe we experienced any delays in refreshes, despite the current asset situation. I wouldn’t say Q4 was atypical compared to previous years. There was likely some normal budget expenditure happening, as well as sales teams making significant efforts to achieve their targets. Additionally, there were deals that were simply postponed. Ken made a valid observation earlier that the SolarWinds incident occurred late in the quarter, at least for us and likely for many other security firms. It's unlikely that this event had much influence on the last two weeks of December during the quarter. However, I think, as Ken pointed out, such incidents raise awareness of security issues. Unfortunately, events like this keep security in the spotlight, reminding people of its importance, especially when there are potential consequences. Regarding the cautious approach you mentioned earlier, I do think we adopted a more careful stance after the second quarter, observing how it affected close rates. This more cautious approach was evident in our guidance for both Q3 and Q4.

Also, we see a pretty nice growth in SMB, but overall, the SMBs still have a very low percentage leverage, whether network security or cybersecurity. We see there’s still a huge growth opportunity over there.

Our next question comes from the line of Andrew Nowinski with D.A. Davidson.

Great. Thank you. And congrats on the nice quarter. Maybe just starting with a high-level question. As we think about the mix of your revenue, do you think the SolarWinds attack will create a positive tailwind for more spending in the firewall market, or do you think it will pressure your product growth as customers perhaps shift spending towards some of your cloud-based and subscription solutions?

I said, probably they would drive to have a more integrated and bigger infrastructure security. It’s definitely sort of when it’s more like kind of come from the network side. On the other side, they are also trying to cover what the pandemic is, whether it’s work from home, there’s a lot of other projects trying to digitalize during this process, which also increased the security need. That’s why I say the security spending kind of on the overall IT spending probably will keep increasing this year, and that’s what’s also helping drive. The SolarWinds case is just like a few years ago, there were cases like Target and other things. Definitely, awareness of the importance of cybersecurity.

Great. Thanks, Ken. And then, just a follow-up. As we think about the growth phase you’re entering here this year and your go-to-market strategy to drive that growth, if you look back over the last few years, your playbook has certainly been to lead with the firewall. I’m just wondering in this new growth phase, are you using the same playbook to accelerate the growth, or are you seeing more deals come to you via your SIM products and your virtual solutions and your other subscriptions and perhaps changing your go-to-market strategy to drive that growth?

In the next few years, the network security market is still the biggest market and probably the fast-growing market, not just because there’s more connectivity like 5G, SD-WAN and some other parts, work from home, but also that’s the center of the whole infrastructure security. But you cannot just focus on network security only; you also need to have network security working closely with the endpoint, with some other infrastructure, cloud, and other parts together. That’s why we call the integrated automated solution to respond to any of these quick changing dynamics in the industry. That’s where we see the organic growth and we also keep developing the product on day one to make it integrated automated together. It’s a little bit different compared to competitors who either come from acquisitions or other parties that is more challenging to integrate and also keep the innovation going forward.

Our next question comes from the line of Gray Powell with BTIG.

Thanks for taking the questions. And congratulations on the good results. Maybe circling back on the 5G questions. In past telecom upgrade cycles, maybe 3G was too long ago, but looking back at the 4G upgrade cycle, how did that play through to Fortinet? What kind of tailwinds did you see then? How does the 5G cycle feel in comparison?

Yes. Compared to 3G, 4G is more about connecting people, whether the phone or whatever, together. The 5G is about connecting devices. The number of connections is likely to increase as it may be 10x at least, because there’s much more devices to be connected. That also addresses a lot of industry needs, whether it’s certain smart cities or autonomous driving or other larger infrastructures. We see a lot of business opportunities because so far, network security will be more towards B2B and the business side compared to the consumer part. We see a huge opportunity going forward. Just like a couple of years ago, the SD-WAN, right? The SD-WAN can help drive a lot of smart connections with the application and become more dynamic based on applications, initiating different connections. That’s where we feel the 5G definitely has a lot of additional opportunity but also brings a lot of risk to the business, which needs to be protected.

Our last question will come from the line of Irvin Liu with Evercore ISI.

I have one question and one follow-up. First, I was wondering if you can perhaps update us on your business mix by customer size, maybe a breakout by enterprise, commercial or SMB. And whether you’ve seen a shift up or down market? And how do you see this mix trending through calendar 2021?

Yes. We had a slide during our Analyst Day in November 2019 that outlined the distribution of our MSSP business, which breaks down into approximately one-third for small businesses, one-third for mid-sized companies, and one-third for enterprises. What really surprised us positively throughout 2020 during the pandemic was how well the small enterprise segment performed; it held up remarkably well.

Got it. And for my follow-up, we’re now one year into the current pandemic. Assuming things normalize in the back half of calendar 2021, do you anticipate any changes or shifts in demand or customer buying patterns, assuming a return to a normal environment?

During the pandemic, customers, particularly in the enterprise sector, tended to stick with their current vendors, especially in developed countries. However, in the U.S. and other regions, we continue to gain market share. We're acquiring many new customers, which has been challenging during the pandemic due to difficulties in meeting and conducting certain tests. As things begin to open up, we see more opportunities arising, especially with our new hardware, operating system, and infrastructure. This momentum is prompting us to invest in growth for the upcoming quarters.

Yes. I think Ken is spot on with that. I think, the nice thing about the pandemic is I think we have a lot of understanding about our business and what to expect in pandemic quarters. I think all of us here at Fortinet, and I think throughout the country are looking forward to, at some point in time, needing a vaccine, and then the other gross drivers will kick in, which seems destined to be sometimes toward the second half of this year. I think we’re all very aware of some of those GDP numbers and the year-over-year swings that we’re seeing from negative 3% to positive 6% or 7%. Those are pretty dramatic numbers. But I think most people’s expectations are that that’s when they are going to come when the economies and the countries start opening up further.

We’re going to close the call at this point. As you read in today’s press release, I’d like to point out that Fortinet’s Accelerate 2021 virtual conference will be held on March 9th for the U.S. As part of that conference, we’ll be doing an Analyst Day. You can register, there’s a link in the press release as well as on the website for investors and analysts. Please do that prior to March 9th if you’re interested in attending that morning event. In addition to hosting Accelerate, we’re also going to be attending the Goldman Sachs conference next week on February 10th and the Morgan Stanley conference on March 2nd. Links to those webcasts will be available on the Investor Relations Events page of our Investor Relations website. Thank you very much for your time today. If you have any questions, please feel free to contact me. Have a great rest of your day.

Ladies and gentlemen, this concludes today’s conference call. Thank you for your participation. You may now disconnect.