Fortinet, Inc. Q2 FY2021 Earnings Call

Good day and thank you for standing by. Welcome to the Fortinet’s Second Quarter 2021 Earnings Call. At this time all participants 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 speaker today, Peter Salkowski, Vice President of Investor Relations. Sir, please go ahead.

Thank you, Kathryn. Good afternoon, everyone. This is Peter Salkowski, Vice President of Investor Relations at Fortinet. I am pleased to welcome everyone to our call to discuss Fortinet's financial results for the second quarter of 2021 which we are hosting from inside of our new building. 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 the Investor Relations website. Ken will begin our call by providing a high-level perspective on our business. Keith will then review our financial and operating results for the second quarter, before providing guidance for the third quarter and updating the full year. We will 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 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 outstanding second quarter 2021 results. Billings increased 35% to $961 million, driven by solid execution and was the best it has been since 2015. Secure SD-WAN contributed 14% of second quarter billings. Total revenue grew 70% to $801 million with product revenue up 41%. Product revenue growth was the highest for nearly 10 years. Free cash flow was $395 million at a quarterly level. With strong business momentum we remain focused on growth. Today we have announced the expansion of our FortiCare and FortiGuard security services, adding a new security service called FortiTrust. FortiTrust security service offers user-based licensing that follows the user across the organizations and provides a high-security platform. This enables organizations to easily manage and secure across all networks, endpoints, and cloud, which traditionally have been siloed. Initial service levels have been offered for Zero-Trust Network Access and identity modifications. We have the current FortiCare security services which cover all Fortinet security fabric products with two-level services to include 24 x 7 technical support and timely insurance resolution. Additionally, FortiGuard security service has been customized for different segments with added individual services for enterprises, commercial, and package solutions for SMBs. Not only are we offering an industry-leading AI-enabled security solution that regularly adjusts protection across the FortiGuard security fabric, but today we announced a new FortiGate - 100F, the industry's first high-performance next-generation firewall, with Zero-Trust network access and advanced protection powered by the Fortinet NP7 SPU that offers an average of two times more performance than other competitive products based on our security features. These enhancements make our solutions the best protection for high-speed internal networks and data centers. We can see the momentum and the adoption of our SD-WAN services across network access and cloud solutions among the world's largest service providers. In May, Fortinet was recognized as the winner of the Microsoft Security award. Lastly, Fortinet has been named Google Cloud's 2020 Security Partner of the Year, recognized for innovative thinking, outstanding customer service, and benefitting from our wide range of products and services. Before turning the call over to Keith, I would like to thank our employees, customers, and partners worldwide for their continuous support of our work.

Thank you, Ken. And to add to your comments, we should note that as of the prior quarter, billings growth, product revenue growth and total revenue growth all accelerated sequentially. In fact, all three growth rates were five-year Fortinet highs and product revenue growth was at its highest in over nine years. Let's drive through a more detailed Q2 discussion with revenue. Total revenue of $801 million was up 30% driven by industry-leading product revenue growth of 41%. The product revenue growth was broad-based across geographies, FortiGate and non-FortiGate products, and across the use cases, illustrating market acceptance and customer demand through our integrated, single-platform security fabric strategy across our customer infrastructures. Our financial strategy includes a rule of 40 target. The target is the total of the revenue growth percentage and operating margin to be at least 40, and the second quarter strong demand and execution drove this actual total to a rule of 55. FortiGate product revenue growth was 40%, while we continue to see robust growth from our secure SD-WAN functionality. The majority of the growth was driven by FortiGate revenue from other capabilities embedded in the FortiGate operating system. Non-FortiGate product revenue growth was over 40% for the second consecutive quarter and was driven by strong growth from our integrated security fabric products. One additional comment on our product revenue growth, the product revenue growth was a reflection of our continued strong organic growth and not the result of a few large deals, drawing down backlog, nor unusual number of delayed transactions from the prior quarter or pulled in from future periods. Service revenue of $503 million was up 24%. Support-related services revenue of $230 million was up 26%, while security subscription services revenue of $273 million was up 23%. Moving to the mix of FortiGate and Non-FortiGate platform revenue, FortiGate product and services revenue increased 26% driven by very strong demand for both branch and high-end FortiGate products. High-end products included 10 NP7 powered FortiGate models, representing approximately 25% of high-end FortiGate shipments. Our ASIC-driven FortiGates give customers five to ten times more computing power than firewalls running on common CPUs. The advanced computing power creates additional speed and capacity to continue to add functionality to our operating system, further driving our price-for-performance advantage. The combination of the ASIC advantage and the common operating system across products can enable vendor consolidation, lowering total cost of ownership, and increasing automation. Non-FortiGate products and services revenue grew 39% and accounted for approximately 30% of total revenue, up over two percentage points. The integrated security fabric consists of a complete range of form factors and delivery methods, including physical and virtual appliances, cloud, SaaS, and professional software, as well as hosted and non-hosted solutions. Together they provide a range of security solutions and form factors, enabling integrated protection for the hybrid environments and the expanding digital attack surface from network data centers to endpoints to the cloud. Let's turn to revenue by geography. To summarize, on Slide 5, revenue in EMEA increased 34%. The Americas revenue increased to 29% and APAC posted revenue growth of 24%. Product revenue growth for both the Americas and EMEA regions was over 40%. Moving to billings, second quarter billings were $961 million up 35%. We saw strong growth in both the FortiGate and non-FortiGate segments of the Security Fabric platform. The FortiGate segment delivered billings growth of over 30%, accounting for 71% of total billings. As shown on Slide 6, branch and high-end FortiGates posted very strong billings growth. The non-FortiGate segment accounted for over 29% of total billings and delivered billings growth of over 45%, driving a 2-point mix shift to non-FortiGate products and services. Given the continued strong performance, we believe our non-FortiGate platform is on pace to be a $1 billion business this year. Secure SD-WAN billings represented 14% of total billings and is a key functionality for an integrated SASE solution. In terms of billings by geographies, EMEA outperformed all geographies, followed by the Americas and APAC. Europe had a very good quarter and growth in the Americas was driven by the United States, which was up sequentially by more than 30 percentage points. Latin America continued to recover from the pandemic-induced slowdown, posting billings growth in the mid-20s for the second consecutive quarter. The average contract term was approximately 28 months, up two months from the second quarter of 2020 and one month in the first quarter of 2021. Deals of over $1 million increased from 59 to 79, and the pipeline for deals over $1 million continues to look good for the remainder of the year. Secure SD-WAN deals over $1 million increased from 13 to 19. Moving to worldwide billings by industry verticals. Billings by vertical illustrate the diversification in our business model, and importantly, suggest the current threat landscape is driving security investments in industries that may have historically shown lower investment levels. For example, the verticals that have historically not been in our top-five combined for billings growth of over 75%. Service providers accounted for 14% of total billings and were up 25%. Moving now to the income statement, product revenue growth of 41% drove a 3-point shift in the product and services revenue mix and along with it a gross margin decrease of 160 basis points to 77.5%. Product gross margin improved to 70 basis points to 61.7%. Services gross margin decreased 160 basis points to 86.9%, with data center investments and FX accounting for about 100 basis points of the impact. Operating margin of 25.4% was at the top end of the guidance range. Despite a 350 basis point headwind from the gross margin decline, a weaker US dollar, and increased travel and marketing event costs. We ended the quarter with a total headcount of 9043, an increase of 17%. Moving to the statement of cash flow, free cash flow for the second quarter came in at a quarterly record of $395 million benefiting from strong revenue growth, good month one linearity and lower capital expenditures. For the quarter, we repurchased approximately 455,000 shares of common stock for a total cost of $92 million, and an average share price of approximately $201. The remaining share repurchase authorization at the end of the second quarter was $921 million, with the authorization set to expire at the end of February 2022. We ended the first half of the year with total cash and investments of $3.4 billion, an increase of $1.7 billion. The increase includes the proceeds from our $1 billion investment grade debt issuance during the first quarter of 2021. DSO's returned to pre-pandemic levels, decreasing seven days year-over-year, and 15 days quarter-over-quarter to 66 days. Inventory turns increased to 2.7 times from 2.2 times, reflecting strong product sales in the quarter. Capital expenditures for the quarter were $24 million and we have started to move into the new Sunnyvale building. We estimate third quarter capital expenditures to be between $65 and $75 million, which includes a $30 million payment for the new campus building. We estimate 2021 capital expenditures to be between $175 and $200 million. With the acceleration of the growth and a little more understanding of the post-pandemic work patterns, we are turning our attention to reviewing our facilities footprint, and the needed office and warehouse capacity in the U.S. and Canada. As we work through this process it is possible that our estimated capital expenditures for the next few quarters will increase as we prepare for the next phase of our growth. Looking forward, our goal remains to balance growth and profitability. Given the growth opportunities that we believe lie ahead, we continue to expect 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, increased sales effectiveness, the growing success of the single integrated security platform strategy, and the convergence of security and networking, the response to the current threat environment, and our development efforts which include continuing to invest in our ASIC advantage which enables a shared operating system across the Security Fabric platform, drives our price-for-performance advantage, and increases the capacity to add features and functions while maintaining price points. I'll now give your outlook for the third quarter which is subject to disclaimers regarding forward-looking information that Peter provided at the beginning of the call. For the third quarter we expect billings in the range of $940 million to $960 million, revenue in the range of $800 million to $815 million, non-GAAP gross margin of 77.5% to 78.5%, non-GAAP operating margin of 24.5% to 25.5%. This includes an estimated 200 basis point headwind from foreign exchange and the increased travel and marketing costs, non-GAAP earnings per share of $0.90 to $0.95, which assumes a share count of between 169 million and 171 million. We expect a non-GAAP tax rate of 21%. With that, we are raising our 2021 guidance and expect billings in the range of $3.870 billion to $3.920 billion, which at the midpoint represents growth of approximately 26%. Revenue in the range of $3.210 billion to $3.250 billion, which at the midpoint represents growth of approximately 24.5%. Total service revenue in the range of $2.045 billion to $2.075 billion, which represents growth of approximately 23% and implies full-year product revenue growth of approximately 28%. Non-GAAP gross margin is expected to be 77% to 79%. Non-GAAP operating margins of 25% to 27%, which includes an estimated 200 basis point headwind from foreign exchange and increased travel and marketing costs. Non-GAAP earnings per share of $2.75 to $3.90, which assumes a share count of between 168 million and 170 million. We expect our non-GAAP tax rate to be 21%. We expect cash taxes to be approximately $90 million. Along with Ken, I'd like to thank our partners, customers, and the Fortinet team for all their hard work, execution, and outstanding success in the first half of 2021. I'll now hand the call back over to Peter, for the Q&A session.

Sure. Our first question is from Brian Essex of Goldman Sachs. Sir, please go ahead.

Great, thank you for taking the quarter and congratulations on the results, really nice set of results this quarter. Maybe to start off, Ken, I know you've talked in the past about not having exposure to final refresh cycles within your business. Could you maybe unpack a little bit the product revenue performance? Are you starting to see perhaps some exposure to the refresh cycles of others? Is this more rip and replace infrastructure upgrades or expansions? Maybe if you can, give us a little bit of an understanding of what's going on behind the product revenue growth this quarter?

Yes, thanks Brian, good question. I have said the industry, whether during the pandemic, after the pandemic probably in some kind of a whole structure changing is no longer the traditional border kind of firewall will be enough. You have to expand into WAN security like 5G and also internal segments protecting the network from internal attacks. So that's where we are seeing consolidation and making a more powerful structure together to protect against attacks. So that's probably different than actually refreshing traditional firewalls. This is a new expanding infrastructure that needs to have our own protection. That's what we see like the programs we announced today, focused on providing security in a high-speed mobile environment and addressing internal segmentation and protection.

Got it, that's super helpful. Maybe to follow up, service provider was slightly lower as a percentage of revenue this quarter. I understand that on the product revenue side and the high end you saw a lot better growth, but should we think about that segment particularly to the extent that they might be selling through for SASE or you might be getting better traction with OPAQ? How should we think about growth in the service provider market? Is that still to come or is that a more stable kind of mid-20s grower segment for you?

I think we are in the ramp-up stage. Compared to last quarter, it probably decreased by about 15 percentage, but this quarter grew about 25%. They are building infrastructure for the 5G and now SASE. We have a different strategy than other players. We are working with service providers to build SASE solutions while also having our own kind of SASE solution, which integrates with our operating system. This is a long-term investment, but with a huge advantage compared to other competitors.

Hey guys, thank you for taking my question. I had a follow-up regarding the drivers of product revenue growth. So Ken, as customers are returning to the office or moving into this more hybrid work environment, and you discussed larger network transformation deals. I'm wondering what the pipeline looks like for those larger deals heading into the back half of the year? And do you think the conditions from the past 12 to 18 months will act as an accelerant for larger infrastructure deals?

We see a strong pipeline for larger multi-product deals, which cover multiple parts of infrastructure. The product revenue growth of 41% indicates strong demand for our products which differ fundamentally from the traditional firewalls that our competitors focus on. The infrastructure needs are changing rapidly, and our ongoing focus on security technologies like 5G will help us meet that demand.

Yes, I think we obviously pay attention to our recruiting and to our attrition rates. The sales headcount actually grew significantly more than our overall headcount increase of 17%. I think we are in a bit of a sweet spot. The success we are having relates to the high-end FortiGates, driven by data center deployments, and some of the branch FortiGates are being driven by visual transformation opportunities.

Yes, thanks guys. For my question, I just wanted to dive into the comment that the majority of growth was driven by FortiGate revenue from other capabilities embedded in the operating system. What does that mean and what capabilities were you referring to that were particularly in demand this quarter?

Yes, I think we tried to make the point in the past that some people view firewalls somewhat simplistically. We track close to 12 to 15 different firewall use cases. If you want to talk about micro-segmentation, IPS, etc., all of those grew together and contributed to the overall success we saw. SD-WAN still contributed nicely at 14% of our total billings, which probably puts it at about 35% or probably 55% growth.

Also, especially with the Fortinet offering, we see strong interest in the cloud areas, in addition to enterprise solutions. Both for service providers and enterprises, we are focusing on providing integrated solutions.

Could you elaborate on your commentary around some of these non-traditional verticals that are starting to see increased spending? Is this more one-time in nature or are these verticals just now starting to wake up to the security issues we read about in the media every day? Also, could you comment on your OT success and strategy?

We're looking at verticals such as manufacturing, transportation, and energy utilities. We have historically talked about our top-five which include financial services, government, service providers, tech, and retail. We saw significant shifts this quarter with much faster growth coming from those other verticals. The OT business also performed very strongly in the quarter.

When we look at the billing upside and revenue upside you've printed, can you unpack for us the mix between your logos and the current installed base? Any qualitative color and discussion will be appreciated.

Yes, new logos were very strong in the quarter, probably up about 50% year-over-year. In the past, we had around 5,000 customers. Obviously, a strong quarter would push it up with new customers signing up with us.

Can you just talk a little bit about the new pricing options that you announced recently? Specifically, do you feel like there is demand for that per user pricing for kind of access to the broader FortiCare and FortiGuard portfolio?

We do see demand for user licensing that can cover multiple devices, including mobile and home devices. The per-user license model will simplify usage for customers needing access to multiple products within our security service offerings. We believe this is an important trend for the future.

I would like to compare where the demand was last year, in 2020, to where it is this year. What has changed both qualitatively and quantitatively that we’re seeing this acceleration?

Last year, the focus was on quickly supporting remote work, but this year, companies see the need for upgraded infrastructures to support long-term security solutions. There is a growing demand for securing various aspects of infrastructure. This change is a bigger shift than traditional refresh cycles.

Yes, we are seeing the benefits of strong growth across various segments including OT. The demand environment is definitely much more robust than it has been in past cycles. We've gained share in many of these areas due to our strategy and technological edge.

I wanted to understand if you're running into any issues around the supply chain or potential chipset shortages. Does this lead to any potential impact on your order cadence at all?

I would love to say that we're completely immune to chip shortages and such, but I can't say that. Our inventory turns suggest that we have a solid stock, but chip manufacturers are focused on meeting the needs for the long haul. I feel optimistic about our manufacturing operations and how we're navigating through these challenges.

Yes, we definitely see customer interest in our security fabric growing steadily, and we believe that positions us well for future expansion and revenue growth.

Thank you, Kathryn. I'd like to thank everyone for joining the call today. Fortinet will be attending the following investor conferences during the third quarter. We're doing the Oppenheimer Conference on August 10 and KeyBanc on August 11. Events with presentations will be webcast, and those links are on our website. If you have any questions following this call, please feel free to reach out to me. And with that, have a great day and take care everyone.

This concludes today's conference call. Thank you all for joining. You may now disconnect.