Fortinet, Inc. Q3 FY2021 Earnings Call

Thank you. Good afternoon, everyone. This is Mr. Peter Zarkowski, Vice President of Investor Relations at Fortinet. I'm pleased to welcome everyone to our call to discuss Fortinet's financial results for the third quarter of 2021. 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 lead our call today, providing a high-level perspective of our business. Keith will then follow with the financial and operating results for the third quarter before providing guidance for the fourth quarter and updating 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 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. 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. While forward-looking statements reflect our opinions only as of the date of this presentation, we undertake no obligation and specifically disclaim any obligation to update forward-looking statements. Also, our references to financial metrics that we make today on this 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.

And thank you to everyone for joining today's call to review our outstanding third quarter 2021 results. Billings increased 42% to $164 million, exceeding our $1 billion quarterly milestone for the first time in Fortinet's history. Global billings growth accelerates to over 50%. Total revenue grew 33% to $857 million, with product revenue up 51%, our highest quarterly product revenue growth since going public in November 2009. We remain focused on growth according to Gartner, the cybersecurity landscape is fragmented with many security teams and tools operating in siloes, and integration can add to the complexity. To address this challenge, Gartner is predicting that by 2024 organizations that adopt our security mesh architecture will reduce the financial impact of individual security incidents by an average of 90%. In a recent report, Gartner highlighted Fortinet's Security Fabric as a platform that offers a cybersecurity mesh architecture approach. Fortinet is helping customers tackle the issue of capacity through our security-driven networking and Security Fabric platform. Our approach offers customers much more security computing power, which results in tightly integrated functionality with better performance, lower costs, and reduced power consumption compared to traditional CPUs. The integration of Fortinet's solutions, such as email security and endpoint protection together with the FortiGate firewall, offers much broader protection while providing better automation than other competitive solutions. As solutions continue to consolidate toward a more robust approach, and as security expands to local and wide area networks, Fortinet is strongly positioned to capture a significant portion of our projected total addressable market of more than $174 billion by 2025. We are confident that this trend, together with our relentless focus on organic innovation, will drive better-than-industry average long-term growth for Fortinet. The COVID-19 pandemic has greatly accelerated remote work. According to Gartner, 75% of workers report that their expectations for working flexibility have increased. Today, Fortinet announced the industry's most complete solution to enable organizations to secure and connect a remote workforce. Our unique Fortinet Security Fabric, with its broad portfolio of advanced security, endpoint, and network solutions, delivers security that follows users whether they are at home, on the road, or in the office. In the 2021 Gartner Magic Quadrant for WAN Edge Infrastructure, Fortinet was named a Leader and ranked number one for our ability to execute. We are also seeing momentum in our secure SD-WAN solutions, with secular trends favoring integrated network security. We continue to see strong demand for our secure SD-WAN as businesses transition to cloud-delivered solutions, including SASE, among the world's largest service providers. This includes partnerships with AT&T, who are rolling out our solutions. I'd like to express my gratitude to our employees, customers, and partners worldwide for their continued support of our efforts.

Thank you, Ken. Let's start the more detailed discussion of Q3 with revenue and the drivers behind our record-setting product revenue growth. Clearly, demand is strong. Our total revenue of $867 million was up 33%, driven by industry-leading product revenue growth of 51%. Analyzing the 51% product revenue growth, our highest quarterly product growth rate in 12 years as a public company, we can identify three drivers. First, the convergence of security and networking, or what we refer to as security-driven networking. Second, strong customer demand for vendor consolidation on platforms. And third, a heightened awareness of today's elevated threat landscape across a broader set of entities. Fortinet is proud to be an innovative leader in security-driven networking. The convergence of security and networking functionality into our integrated security fabric platform enables us to provide integrated security at networking speeds from the data center to end-points and the cloud. Our recently announced unified solution enables organizations to secure and connect a remote workforce by combining our endpoint and network security solutions. The demand for vendor consolidation is increasing as customers look for an integrated and single platform approach to security that effectively protects against a wide range of attack vectors. Our security fabric platform provides a broad range of integrated security products to address this demand. Gartner recently recognized Fortinet Security Fabric as a platform that offers a cybersecurity mesh architecture approach. The cornerstone of our cybersecurity mesh architecture is our FortiGate firewalls, providing on average 5 to 10 times more computing power than competitor firewalls. This greater computing power allows our engineers to incorporate additional security functionality and integration into our operating system, enhancing our price-to-performance advantage. The integration extends across our suite of security fabric solutions, which consist of a complete range of form factors including physical and virtual appliances, cloud, SaaS, and perpetual software. In response to the significant increase in the number of ransomware attacks, there is now greater awareness of the need for cybersecurity technologies. According to our latest global threat landscape report published by FortiGuard Labs, the number of unique ransomware attacks increased more than tenfold from July of 2020 to June of 2021. The combination of security and networking convergence, the adoption of a cybersecurity mesh architecture, and the heightened awareness of the threat landscape drove our record-setting product revenue growth and contribute to market share gains for Fortinet. The robust product revenue growth was broad-based, with both FortiGate and Non-FortiGate solutions posting growth rates of approximately 50%. Our service revenue of $530 million increased 24%, with support and related services growing 26% to $243 million and security subscription services revenue rising 22% to $287 million. Moving on to billings, we crossed the $1 billion threshold for the first time in our history, at $1 billion, $64 million, up 42%. This demonstrates a robust response from enterprises to the expanding threat landscape favoring integrated platform strategies. This is particularly evident in the large enterprise segment, where Global 2000 billings grew 52% over the last three consecutive quarters. We added over 6,000 new logos across all customer segments for the second consecutive quarter. Billings from FortiGate products increased 39% and accounted for 70% of total billings. Entry-level and high-end FortiGate product revenue grew 60% and 57% respectively. Non-FortiGate billings rose 49%, shifting the billings mix toward Non-FortiGate products. The top ten solutions accounted for 68% of Non-FortiGate billings, showing growth of 48%. The number of deals over $1 million increased by over 70% to 83 deals and secure SD-WAN deals more than doubled to 19. The average contract term extended to 29 months, driven by significant growth in Global 2000 and large enterprise deals. SD-WAN billings grew 52%, outpacing the overall billings growth, making up approximately 14% of total billings. Fortinet was named a leader in the Gartner Magic Quadrant for WAN Edge infrastructure for the second consecutive year and positioned number one for ability to execute.

I feel we are in a better position compared to competitors. First, we have much larger volume than our competitors—possibly three times compared to some competitors—allowing us better negotiation power. We manage all aspects more directly compared to others, which gives us better visibility and the ability to respond quickly. Second, we have a wide range of product offerings. By bolstering FortiGate, we enable customers to easily upgrade to other products with similar performance, all running on FortiOS. This makes it easier for customers to transition when they experience shortages with other products. Additionally, we have a great operations team and have a culture focused on maintaining inventory compared to our competitors, as we tend to keep more inventory on hand to address urgent customer needs.

Great. Good afternoon. Thank you for taking the question and congrats on some really nice results this quarter. I guess, Keith, you spent some extra time talking about the supply chain, which has certainly been the most frequent question I've received from investors recently. Could you help us understand what kind of headwind you're quantifying or accounting for in your Q4 guidance? Where do you see risks in the supply chain? And what might you be seeing from peers, particularly where you may be benefiting from supply where your peers may not have products available?

Thanks, Brian. I don't know that anyone has all the answers to the questions you've raised. I'll provide some context as best I can. We saw a bit of supply chain pressure in both the second and third quarters, but nothing significant. I feel that the guidance we’ve provided for Q4 is appropriately conservative in terms of supply chain risks or backlog concerns. There is some backlog appearing in some of our fabric products, particularly Non-FortiGate, which may continue into Q4. Looking out to 2022, everyone is trying to assess when we will see real market improvement.

I feel we are in a better position compared to competitors. First, our volume is much larger, giving us better negotiation power. We have visibility and can react more quickly. Second, our broad product line makes it simpler for customers to transition between products, which is advantageous during shortages. Lastly, we have a strong operations team committed to maintaining inventory, enabling us to manage customer needs effectively during supply chain challenges.

Hey guys, you're making this one question format hard for me. I want to focus on the growth acceleration. Your product revenue growth went from 25% to 41% to 51% over the last three quarters. Likewise, billing growth jumped from 14% to 35% to 42%. Can you identify which key areas are contributing most significantly to this acceleration? Can you also provide an update on SD-WAN specifically?

Both FortiGate and Non-FortiGate products are experiencing revenue growth around 50%. FortiGate is crucial for our customers’ communications security needs. Non-FortiGate products are linked to our security fabric, which according to Gartner can help reduce financial costs from security incidents by up to 90%. This is a significant driver of growth. Additionally, we are witnessing vendor consolidation as smaller suppliers begin to weaken, leading to market share gains for us.

I would like to echo Ken's sentiment. The threat landscape is a hot topic currently and won't likely diffuse anytime soon. Our capabilities—built around security and networking speeds—are critical. Moreover, the cybersecurity mesh architecture approach we are fostering, along with partners, emerges as more companies seek consolidated solutions. We believe these supportive trends will continue into 2022.

Thank you. Congrats on the performance and guidance, guys. Keith, the federal vertical performed well. Was this just typical Q3 government seasonality, or do you expect this to be sustainable going forward, given your recent investments in that vertical?

Keep in mind that our government sector encompasses global, U.S. federal, international, state, and local governments. This vertical has shown strong performance for over a year or two. Given the investments by Ken and the team, particularly in the U.S. Federal sector, I see potential for further growth in this area moving forward.

Hey, guys. I want to dive deeper into the FortiGate side. Can you help me understand the purchasing taking place? Are we modernizing data centers or seeing expansions? Is this displacements or are these investments surprising, considering the shift to the Cloud?

What we've seen comes down to the sales team’s execution. We've recently experienced robust product suite performance across the board. There was no weak geography or product line. Our sales team successfully articulated the platform strategy, which contributed to strong execution this quarter.

The global market is showing strong growth, exceeding 58%. Our strategy seems to be paying off, especially with major service providers invseted for long-term gains.

Hi guys. My question extends on what Michael just discussed. Can you characterize how much of your growth is coming from actual displacement of solutions versus existing customers buying additional products?

We added 6,000 new logos, indicating that we are getting more opportunities. There has certainly been greater penetration into our existing customer base. It's noteworthy that we've had 6,000 new logos for two consecutive quarters now, and some of these are small enterprises. More opportunities are leading to stronger execution.

Thanks for taking my question. I want to pivot a bit and ask about the G2000 specifically. What's driving the strength in G2000 billings? Is that product-related or has it been better distribution relationships? Who do you think the market share is coming from?

In terms of market share dynamics, I wouldn't have any surprises in mind. The individuals I'm referencing here likely align with expectations. Regarding our distribution strategies, particularly with large enterprise-focused distributors in the U.S., we have invested significantly in time and resources to facilitate opportunities and demonstrate superiority in our offerings, and our efforts are beginning to pay off.

Hey guys, thanks for taking my question. I noticed that your OT revenues grew 77% this quarter. Can you provide any context around how significant that's becoming to your overall billings and what's driving that growth in recent quarters?

While it's not as big as SD-WAN, OT is experiencing faster growth. I would say that it's reached a size that we find it valuable to share these growth levels outside the company. Combined, SD-WAN and OT would account for over 20% of our total billings.

Hey guys, thanks for taking my question. Ken, back in September, you partnered with Linksys to enhance work-from-home security. Could you elaborate on securing home networks as extensions of the workplace and what that opportunity looks like as we continue living in this work-from-anywhere environment?

It's a new market with significant potential, especially in supporting work-from-anywhere. We believe this partnership with Linksys will be crucial as IoT devices begin to proliferate. The rapid transition of our workforce to remote environments increases the need for robust network protection, which we are well-positioned to provide. While growth is expected, it will ramp up gradually.

Hi, good afternoon. Congrats on the strong results. I want to understand the dynamics around the price increases you've implemented. Could you provide some insight on the impact of these price changes this quarter, and the potential for them to sustain beyond current supply chain challenges?

We implemented cautionary price increases based on cost increases, supported by our partners. Our higher performance-to-price ratio means there is room for price adjustments without significant pushback from customers, as our product offering remains highly attractive.

Regarding our ASPs, we factor the impact of price increases into our strategy. Our overall price actions met with acceptance from customers. We believe these price adjustments have positively influenced our margins for the quarter, while also being mindful of cost variables.

Can you provide a rough estimate of how much of your Non-FortiGate revenues come from appliances versus software and Cloud? How should we anticipate supply chain issues impacting Non-FortiGate in Q4?

In terms of Non-FortiGate revenue, around 30% to 40% comes from Cloud or software. The remainder is from hardware form factors. The supply chain pressure we encountered in the third quarter primarily impacted Non-FortiGate areas, especially switches and access points.

Thank you, and congrats on a fantastic quarter. I would like to know what drove the strength in high-end FortiGate sales, which have been elevated relative to past quarters. Could you speak to the influence of 5G rollouts and your leadership position in that market?

The substantial growth from the Global 2000 enterprises has fueled high-end FortiGate sales in a significant way. Our product refresh over the past few years has led to performance improvements. While we're seeing good traction in SD-WAN deployments with some contribution, we anticipate much larger growth potential as 5G ramps up.

Hi, thanks for the question. For either Ken or Keith, can you discuss customer traction post-security summit event? Did you notice any uptick in visibility and mindshare from customers as a result?

I was extremely impressed with how the event turned out. We had significant engagement with both existing and potential customers. The event served as an effective platform for customers to connect and learn about our offerings, which I believe has driven enhanced visibility and market engagement.

This was one of our largest marketing investments, and it paid off significantly. We can see a quantifiable positive response from customers and partners who attended. The networking opportunities provided by this event have further strengthened our relationships while generating considerable buzz in the market.

Thank you very much. I wanted to ask for clarification on the billings guidance. Your fourth-quarter guidance suggests that sequential growth might be about 13%, while in previous years, you have demonstrated about 28%. Can you provide color on why the shift? Is it concerned with supply chain availability?

You're right that supply chain issues primarily factor into our guidance. We are conservatively estimating that we'll still face some supply constraints. Considering this, we feel good about the guidance we provided. Overall, though, the underlying health of our business remains strong, as indicated by our bookings.

Could you also share about the non-FortiGate mix? How do you see that evolving over the next couple of quarters?

We do see a strong demand from our customers for our security mesh architecture, which will drive non-FortiGate revenue growth. The progress we're making through SaaS and managed solutions will also aid in expanding our customer base, amplifying demand.

Thank you, Eli. I'd like to extend my gratitude to everyone for joining the call today. I know you have numerous calls this evening, and I genuinely appreciate your time. Fortinet will be attending several investor conferences in the fourth quarter, including the Wells Fargo Conference on November 30th, the NASDAQ Conference on December 1st and 2nd, the UBS Conference on December 7th, and the Barclays Conference on December 8th. Presentation details will be available on the Investor Relations website. We invite you to reach out if you have any follow-up questions. Have a good day. Thank you again.

And this concludes today's conference call. Thank you all for participating. You may now disconnect.