Fortinet, Inc. Q2 FY2022 Earnings Call

Good day, and thank you for standing by. Welcome to the Fortinet Second Quarter Earnings Call. At this time all participants are in a listen-only mode, after the speakers’ presentation, there’ll be a question-and-answer session. Please be advised that today’s conference call is being recorded. I would now like to hand the conference over to your speaker today, Peter Salkowski. Please go ahead.

Thank you, Hope. 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 financial results for the second quarter of 2022. 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 operating results for the second quarter before providing guidance for the third quarter, updating the full year. We’ll then open the call for questions. During the Q&A, we ask that you please limit yourself to one question and one follow-up question to allow for 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 mention in today’s call are non-GAAP, unless stated otherwise. Our GAAP results and GAAP to non-GAAP reconciliations are located in the earnings press release and in the presentation that accompany today’s remarks, both of which are posted on the Investor Relations website. Ken and Keith’s prepared remarks today for the earnings call will be posted on the quarterly earnings section of our Investor Relations website immediately following today’s call. Lastly, all references are on a year-over-year basis, unless noted otherwise. I’ll now turn the call over to Ken.

Thanks Peter. Thank you to everyone for joining today’s call to review our outstanding second quarter 2022 results. Total billings increased 36%; the fifth consecutive quarter of at least 35% year-over-year billings growth. Revenue grew 29% driven by 34% product revenue growth. SD-WAN and OT bookings grew over 60% and 75%, which together accounted for 25% of total second quarter bookings. Our better-than-expected performance demonstrates the strong demand for our cybersecurity innovation. Fortinet is at the forefront of networking and security convergence, enabling our customers to reduce complexity while securing and connecting hybrid and remote users to advanced security with superior performance. Today we announced the FortiGate 4800F, our latest innovation in converged Network Security. The 4800F is the world’s fastest compact firewall for hyperscale data centers and 5G networks. Powered by Fortinet’s NP7 SPU, the 4800F delivers Security Compute Ratings that, on average, provide 5-10 times better performance than competitive solutions across the six most common and important functions. A leader in the Gartner Magic Quadrant for WAN Edge Infrastructure, Fortinet continues to take market share for Secure SD-WAN. Our integrated secure SD-WAN solution, powered by Fortinet’s SPU SOC4, delivers massive performance, security, and efficiencies over traditional offerings. In addition to convergence, consolidation of vendors and product functionality is another major trend, particularly in Network Security. In a recent CISO survey, Gartner found that the percentage of companies surveyed who want fewer security providers increased to 75% from only 29% in 2020. With over 30 product lines built mostly by our in-house strong engineering and development innovation, Fortinet is benefiting from this consolidation with our Security Fabric MESH offering. The Fortinet Security MESH platform delivers unparalleled protection with broad, integrated, and automated protection across multiple edges, from endpoint, to data center, and hybrid cloud environments. These two major trends, convergence and consolidation, position Fortinet well for long-term growth. Before turning the call over to Keith, I’d like to thank our employees, customers, partners, and suppliers worldwide for their continued support and hard work that are contributing to Fortinet’s strong growth.

Thank you, Ken, and good afternoon, everyone. Let’s start the more detailed quarterly discussion. Second quarter results were solid and broad-based across geographies, customer sizes, industries, and use cases, driving market share gains and demonstrating the strong support from our three key growth drivers: first, an elevated threat environment; second, the convergence of security and networking; and third, the consolidation of security products across our platform offerings. Total revenue of $1.03 billion was up 29%, passing the $1 billion milestone in quarterly revenue for the first time in our history. Total product revenue growth was up 34%. Core Platform and Platform Extension product revenue growth was up 35% and 33%, respectively. We continued to see robust product revenue growth from a wide range of security use cases, including Secure SD-WAN and Operational Technology, or OT. Total service revenue growth increased sequentially to 25%, resulting in service revenue of $629 million. Support and related service revenue was up 26% to $289 million, while security subscriptions service revenue was up 25%, or 2 points sequentially, to $340 million. Service billings, defined as total billings minus product revenue, were up 36%. The year-over-year growth rate for short-term deferred revenue has increased for six quarters in a row from just under 21% in Q4 of 2020 to just over 31% in Q2 of 2022, the highest short-term deferred revenue growth rate in over six years. The accelerating growth rates for service billings and short-term deferred revenue reflect the earlier pricing actions that quickly appeared in product revenue and that are now beginning to appear in service revenue. The pricing benefit more than offset various service revenue headwinds, including suspending services in Russia, an increase in the average number of days between when a customer purchases and subsequently activates a security service contract, and the impact of contract manufacturers delaying deliveries to later in the quarter, which limits our service revenue on new sales recognized in the quarter. With growth and pricing benefits more than offsetting these headwinds, we expect service revenue growth will continue to accelerate through 2022 and into next year. As summarized on slide 6, total revenue in the Americas increased 23%, EMEA revenue increased 28%, and APAC posted revenue growth of 42%. Despite macro conditions that may be more readily impacting other industries, our pipeline growth remains strong. In particular, EMEA’s pipeline growth indicates continued strength in our European business. Moving to a summary of our success with large enterprises. Large enterprises continue to favor Fortinet’s leading cost performance advantage and are increasingly more appreciative of our integrated platform. The platform strategy allows customers to converge networking functionality with security capabilities and consolidate multiple point products. Our success with large enterprise customers includes: global 2000 bookings growth of over 65% year-over-year and on a rolling four-quarter basis; large enterprise bookings growth of over 55% year-over-year and on a rolling four-quarter basis; and the number of deals over $1 million increased over 50% to 122 deals, and the total billings value of these transactions doubled. Secure SD-WAN bookings grew over 60%, reflecting the convergence of networking and security as well as a strong ROI for our customers. OT bookings were up over 75%, reflecting the continued response to the elevated threat environment. Shifting to billings, billings of $1.3 billion were up 36%, as Ken pointed out, representing the fifth consecutive quarter of billings growth in excess of 30%. I’ll pause here to offer thoughts on product refresh cycles and their impact on our financial results. Specifically, we do not believe new product releases drive a near-term spike in our top-line growth; rather, we believe the continual nature of our product releases drives long-term growth. For example, each new ASIC is included in a series of products released over several years. Our most recent ASIC chip, the NP7 Security Processing Unit, was introduced in Q1 of 2020. Including the 4800F announced today, we have released 9 high-end Core Platform products with the NP7 chip. Over the next several quarters we will release several additional mid-range and high-end products with the NP7. Lastly, I would note that since the start of 2019, we have released over 23 new FortiGate models. While some of our competitors with much shorter product SKU lists may have shown clear signs of product refresh cycles, our strong long-term performance illustrates an extended series of overlapping product maturity curves. Core Platform billings were up 32% and accounted for 69% of total billings. As shown on slide 7, mid-range FortiGates posted very strong billings growth with the mix shifting 5 points in their favor driven by demand as well as supply availability. Platform Extension billings were up 44% and accounted for 31% of total billings, a mix shift of over one and a half points. Average contract term was up one month year-over-year at 29 months, driven by the strength from large enterprise customers and the 50% plus increase in the number of deals greater than $1 million. Moving back to the income statement. Total gross margin of 76.5% exceeded the midpoint of the guidance range by approximately 125 basis points, even as components, labor, and freight costs increased, and the year-over-year revenue mix shifted 2 points to product revenue from higher margin service revenue. Product gross margin of 61.9% was up 20 basis points year-over-year and 450 basis points sequentially as pricing actions, product mix, and lower discounting offset higher component and other costs. Service gross margin of 85.9% was down 100 basis points due to increased costs associated with the expansion of our data center footprint, as well as labor costs and other costs; partially offset by benefits from FX and some of the earlier pricing actions. Operating margin of 24.8% exceeded the midpoint of the guidance range by approximately 200 basis points. The year-over-year comparison saw the FX benefit offset by lower gross margins, increased travel and marketing costs, and other costs. Headcount increased 27% to 11,508. Looking to the statement of cash flows summarized on slides 8 and 9. Free cash flow was $284 million and was impacted by increases in DSO and cash taxes. DSO increased 14 days year-over-year and 5 days sequentially to 80 days due to the change in billing linearity driven by the timing of inventory deliveries from contract manufacturers. New R&D capitalization rules increased second quarter cash taxes by $85 million to $110 million. Second half cash taxes of approximately $135 million are expected to be more evenly spread across the third and fourth quarters. For the first half of the year, our adjusted free cash flow margin, which excludes real estate spending, was 34%. Capital expenditures for the quarter were $39 million, including $21 million for real estate investments. We repurchased approximately 14.4 million shares of our common stock for a cost of $800 million, bringing the total year-to-date shares repurchased to 25.8 million for a total cost of $1.5 billion. The Board increased the share repurchase authorization by $1 billion. The remaining repurchase authorization is now $1.03 billion. Inventory turns of 3.1 times were up a half turn year-over-year and down a half turn sequentially. Moving to bookings and backlog. As a reminder, backlog is excluded from the current quarter billings and revenue. Nonetheless, it is expected to provide increased visibility and a top-line tailwind in future quarters. Bookings were up 42% to $1.4 billion. Total backlog of $350 million is up $72 million sequentially and reflects very strong demand. Of the total backlog, networking equipment accounted for about 50%, while FortiGates accounted for 40%. We believe our backlog is very strong and sticky. Existing customers account for over 95% of total backlog and no single end customer accounts for more than low single digits as a percentage of backlog. There are four deals in backlog, all from previously existing customers, with a remaining balance of over $2 million that together account for 6% of total backlog. Just 4% of ending Q1 backlog was canceled in Q2, and about half of the deals in backlog have been partially fulfilled, suggesting that double ordering is not a significant contributor to backlog. Consistent with the first quarter, we shipped approximately 60% of the prior quarter’s backlog in the current quarter, as our operation and R&D teams did an excellent job navigating the tough supply chain environment. Nonetheless, we still expect supply chain constraints to be challenging throughout the remainder of the year. We are continuing to address the supply chain challenges in a number of ways, including by increasing inventory purchase commitments, redesigning products, qualifying additional suppliers, and certain pricing actions. We believe that even with these actions, demand will continue to outstrip supply. As a result, we expect backlog to continue to increase in 2022; and while the situation is very dynamic, we believe we will have access to sufficient inventory to meet our guidance. As we balance our pricing actions with the opportunity for continued market share gains, we have passed along most, but not all cost increases. As such, we expect ongoing gross margin volatility from these increases, as well as shifts in our product mix related to inventory availability. Before reviewing our guidance, let’s offer a few Fortinet specific observations in areas you may have heard discussed elsewhere. In Q2, we noted certain larger transactions with increased or elongated negotiating cycles. Also, linearity pushed to later in the quarter, and later in the last month of the quarter, mainly due to supply constraints and the delivery. Lastly, close rates were strong and, importantly, the aggregate value of deals that pushed out were within our historical norms. Now, I’d like to review our outlook for the third quarter as summarized on slide 10, which is subject to the disclaimers regarding forward-looking information that Peter provided at the beginning of the call. For the third quarter, we anticipate our solid third quarter pipeline growth across deal types, sizes, and geographies to support the following: Bookings in the range of $1,455 million to $1,485 million, which at the midpoint represents bookings growth of 36%; billings in the range of $1,385 million to $1,415 million, which represents growth of 32%; revenue in the range of $1,105 million to $1,135 million, which represents growth of 29%; non-GAAP gross margin of 75% to 76%; non-GAAP operating margin of 25% to 26%; non-GAAP earnings per share of $0.26 to $0.28, which assumes a share count of between 810 million and 820 million; we estimate third quarter capital expenditures to be between $105 million and $115 million; we expect a non-GAAP tax rate of 17%. For the full year, we anticipate backlog that could approach or possibly exceed $500 million that will be offset by robust industry growth, pipeline strength, and market share gains fueling our growth and support the following: Billings in the range of $5,560 million to $5,640 million, which at the midpoint represents growth of 34%; revenue in the range of $4,350 million to $4,400 million, which represents growth of 31%; total service revenue in the range of $2,620 million to $2,670 million, which represents growth of 27% and implies full-year product revenue growth of 38%; we expect non-GAAP gross margin of 75% to 76%; non-GAAP operating margin of 25% to 26%; non-GAAP earnings per share of $1.01 to $1.06, which assumes a share count of between 810 million and 820 million; we estimate full year capital expenditures to be between $300 million and $330 million; we expect our non-GAAP tax rate to be 17%; we expect cash taxes for the year to be $265 million, as I mentioned earlier, cash taxes paid are higher in 2022 due to the new R&D capitalization rules in the U.S. Along with Ken, I would like to thank our partners, customers, suppliers, and all members of the Fortinet team for all of their hard work, execution, and success. I’ll now hand the call back over to Peter to begin the Q&A session.

Thank you, Keith. As a reminder, during the Q&A session, we ask that you please limit yourself to one question and one follow-up question to allow others to participate. With that, Hope, please open the call for questions.

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

Thank you. Good afternoon and thanks for the questions. Congratulations to the team on strong results for the quarter. I’d like to discuss the commentary on the services side and the reduced services revenue guidance for the year. Can you help us understand what's happening there? Additionally, could you address the delays in activations and provide insight that reassures us there isn't a pull-forward? Thank you.

I don’t believe that the concept of pull forward really applies to the service revenue line. In response to your question about service revenue, the most significant change from the beginning of the year is related to Russia. Russia constitutes about 1.5% of our total revenue, which also affects the service revenue line. Earlier this year, we stopped recognizing revenue from existing contracts for services provided in Russia as we suspended our services there. Initially, we did not expect this to be a full-year situation, but we have now adjusted our outlook. If we consider that 1.5% of service revenues in Russia, we have factored out approximately $25 million of revenue related to Russia for the full year. That represents the largest change. Regarding the delay in registrations from when contracts are sold to when customers actually register them, we achieved what we anticipated for the quarter. This seems to be influenced by the current environment and inventory constraints, which are likely to persist. The linearity aspect is somewhat new because the shipments occurred later in the quarter, and as a result, we did not capture the service revenue from those second-quarter shipments as we typically would. Additionally, I would like to highlight the short-term deferred revenue billings and the growth in service billings as well. One final point is that the service contracts operate as a use-it-or-lose-it contract. Customers do not have the option to cancel; however, they can postpone registration for a certain period depending on the geography, which could be 90 days or up to a year. Ultimately, this will convert into revenue, but the timing has been delayed.

Hey. Keith, this one’s for you. Just with respect to some of the backlog detail and commentary that you shared, I want to hone in on the cancellation rates that you quantified for us. I believe you said it was about 4%. Can you give us a sense of what are some of the reasons behind the cancellation? And what gives you confidence that that 4% isn’t going to stretch or escalate into maybe mid to high single digits? Thank you.

Yes, I would like to highlight some factors we've discussed previously. Last quarter, we noted a cancellation rate of 5%, which has now decreased to 4%. It's unlikely that existing customers, especially those who have received partial shipments, will cancel their orders. I don’t want to overlook the fact that as backlog ages, there is an inherent risk, which is why we mention that 60% of shipments come from previous backlog to help people understand the situation. If that percentage begins to rise, it would indicate more risk. It's crucial to recognize that our guidance does not suggest any significant change in the backlog, as we plan to ship a lot from it. We are being quite cautious in this regard, and we feel confident about the stability of the backlog number.

Maybe just on the macro. You talked a little bit about the demand environment and highlighted some delayed deals and elongated linearity. Can you maybe go a little bit deeper here and talk about what these customer conversations look like? Are these tied to any particular verticals or geographies? You talked a little bit about large enterprise or larger deals. I’d love to hear about the midsize to smaller deals, too. Thanks.

It’s Ken. So, we do see a lot of customers, especially enterprises, starting to design some new infrastructure to support work from anywhere and also expand security beyond the traditional network security, to internal segmentation to prevent ransomware attacks, or go to work from home and at the same time have multiple security products need to be automated together. So we see this kind of consolidation on both the product side and the vendor side. I see this trend will last for the next few years; it will be a pretty long-term change. And at the same time, Keith also mentioned the elevated security environment as a driver. That’s where we see the trend continuing for the next few years. If you look at the billing number compared to two years ago, I mentioned in my script that we have over a 35% billing increase in the last five quarters compared to two years ago—Q1 2020, which had only about a 14% growth. So, we do see a change in acceleration and the convergence and consolidation going on in the whole space right now that will be a significant driver of growth.

Keith, maybe for you. I’d like to talk a little bit about bookings. Can you just talk about how bookings did versus your expectation this quarter? I think the guide coming into Q2 was for about 40% growth. We came in at 42%, clearly better, but a bigger delta on the billings versus the guide. Can you just talk about how to read into that, if there’s anything to consider there with just those two kind of in relation to each other?

Yes. I think, obviously, 42% bookings is a great number. I think we’ve been over 40% now for 3 quarters, maybe 4 quarters on the bookings line, and we feel really, really good about it. I think the one thing we’re looking at internally is the interplay between bookings, backlog, and billings, and trying to get a sense of the direction of the business. The example I kind of gave is we had a very good quarter on the midrange of the product. But some of that was due to availability. Demand was very strong, but it was also because we had the midrange product available. We didn’t have as much product available in the low end. Now, as we shifted to this third quarter, I think we’re probably going to see the low end availability improved fairly dramatically. When you’re looking at billings information that we have historically disclosed and trying to gauge the direction of the business, it gets a little bit distorted now just in terms of what’s available. I think for the total, when you look at bookings and backlog, there’s some of that in terms of the characterization of what the booking is versus what’s available to ship and what comes in the billings line.

Keith, you talked in the prepared remarks about still expecting supply challenges for the rest of the year and to offset, you’re thinking of increased purchase commitments, qualifying additional suppliers, and pricing actions. I wanted to zoom in on that last point on pricing actions to see if you would maybe put a finer point on timing and magnitude for expected pricing actions? And secondly, you sounded positive on elasticity and confident on the elasticity moving forward. But just curious what underpins that confidence, especially in international markets with dollar strengthening in local currencies and fixed budgets, etc. Thank you.

I appreciate the question. I'll address the second part first as I believe it's quite significant. We meticulously track in our CRM system the reasons behind any lost deals. If we do lose a deal, we analyze the cause. Is it due to the current provider's hold on the customer? Did a channel partner show a preference for a competitor? Was it related to features or functionality? We also focus specifically on whether we lost because of pricing. This tracking has been underway for over a year, and we’ve found that the percentage of losses attributed to price is consistently lower than other factors. This consistent loss rate allows me to assess price elasticity, indicating how far we can stretch our pricing strategy. We enter negotiations with a considerable advantage in both price and performance, and we’ve established that we can present a difference of about 30% to 40%. We have understood this from the start of this economic cycle. Our objective is to align with cost increases over time while maintaining a stable margin. To summarize, I strongly rely on the insights from our CRM data regarding the reasons behind our successes and failures in closing deals.

Yes. Additionally, I want to make a few comments about pricing. Our approach is usually to raise prices gradually, but we are flexible and release a new pricing structure every quarter. Furthermore, the product we launched today usually performs ten times better than competitors for the same function and price range. As Keith noted, with CRM tracking, we haven’t experienced significant loss from changes; in fact, our pricing advantage remains strong. Regarding service, we aim to make improvements moving forward, especially since we've increased prices on new product releases in the last few quarters while keeping prices steady for older products. Those products continue to be included in the service, which can enhance the service experience and help improve margins to offset rising costs, particularly in labor.

So, Keith, I have two questions. First, it may seem obvious, but do you think the linearity issue and the extension of the negotiation cycle are tied to the current macroeconomic conditions, or do you have other insights? Second, do you believe that the shortfall this year is primarily due to services, and are you satisfied with the product?

Yes, I believe that looking at the situation, it’s important to note that there has been a shift in our business dynamics. While typically, we can analyze linearity and days sales outstanding to gauge if a company is pushing to close deals at the end of a quarter, this time we have experienced a change due to the timing of inventory deliveries from our contract manufacturers. This shift affects when we can conduct quality assurance and ship products to our customers, ultimately impacting our sales. Consequently, service contracts that would usually be sold in the first month of the quarter ended up being sold in the third month instead, which resulted in a loss of service revenue. This effect is visible in our days sales outstanding and free cash flow. During the first two weeks of June, we observed increased discussions about a potential recession, which led to a temporary slowdown in deal closures. However, as we approached the end of June, we saw a rebound in activity. I also noticed that additional stakeholders were being introduced in some of the larger negotiations to ensure customers made well-informed decisions. It's noteworthy that despite this brief slowdown, our close rates improved slightly during the quarter. It appears that there was just a short pause in early June, but this was followed by a significant push to complete deals by the end of the month.

The other reason for a little bit longer closing time really is that bigger deals grow faster. So, like I mentioned, the deals over $1 million grew over 50% year-over-year. So, those larger deals tend to take a little bit longer time to close. We also see more deals involving multiple products, not just the FortiGate, but also we call the non-FortiGate, called the platform retention, which also takes a little bit longer to test and evaluate to close. On the supply chain, since really compared to before the pandemic, we shipped the majority of most products by sea. Now we’re shipping every product by air, which makes the timing of the supply chain shipments to us pretty critical. In the last quarter, we did experience a lot of product being shipped at the end of the quarter from suppliers to us, which drives the linearity. Even if we have the booking, we are still waiting a few weeks or even a couple of months before the product was shipped to the customer towards the quarter end because the supply shipping goes towards the end of the quarter. So, we do see that this will improve in the long term. We’ll keep increasing some of the product inventory and improving the product turn and balance, not just shipping everything by air, but some by air and some by ocean.

Good segue from Michael’s question. Keith, I want to try to understand, you talked about a few different things impacting the year guide. To put context around it, your revenue guide for ‘22 isn’t changing, which I think is viewed as a disappointment to investors. Now underneath that, services revenue is getting compressed a little bit. As you think about why the revenue estimates are going higher for the year, is there a change in, a, the demand level, whether it’s the elongation you mentioned because you said, in fact, there was two weeks of weakness at the end of June, but it sounds like during the last through the third of August, things have normalized? Is it b, supply chain issues that are causing you to not raise your revenue guidance even as you’re raising billings modestly? I’m just trying to understand what are the forces that are impacting the lack of raise?

Yes. I don’t really think it’s necessarily either demand or supply. I would start the conversation off by saying I think the pipeline growth is extremely strong. We feel very, very good about that. I do think there’s a fair amount of uncertainty as we look out beyond the third quarter to the fourth quarter in terms of directions the economies may go, what inflation may do, and a little bit of supply chain. I don’t think—we did, as you point out, cover the shortfall in the service revenue in product revenue. So I think that’s a fairly good size of us being bullish and feeling very, very good about our competitive advantage. I think the other aspect we talked about is just the large deals and how we’re seeing success in the enterprise. We’re getting a little more dependent on large deals than we have in prior years and some of the close rates around those. While we’re bullish, we think we have competitive advantages. I don’t know as we get to the fourth quarter if this is really a good time to think about it in a very aggressive fashion.

Maybe segueing from the prior question from revenue maybe to OpEx. So, your hiring plans appear to remain largely on track. What’s the current thinking on the second half? Is it becoming a little easier in recent months, given some layoffs at some private competitors?

We want to maintain healthy margins while also keeping growth and gaining market share. Hiring is relatively a little bit easier compared to a few quarters ago, especially in the cybersecurity space. For us, we feel we have a good pace on hiring, especially as we continue to gain market share. The margin is healthy, with both gross and operating margin side remaining solid. So, we feel we have a pretty solid plan and balance among growth and margin.

Yes. I think Ken’s spot on with that. I would probably offer a couple of things to support this. One is you continue to hear us talk about our inventory commitments looking out now six quarters or more. The read through is that we still feel fairly bullish about it. The other aspect that Ken made reference to is we talk about 25% operating margins in different ways over the years as being an average or target. To come in successfully in this environment and still provide guidance for the full year of 25% to 26%, while growing the top line aggressively and taking market share, I think we feel very good about how the sales team, engineering team, operations teams, and support teams are all working together and driving the growth of the Company and the execution.

Maybe a question for both, Ken and Keith. Ken, just given the general pressure on budgets in the macro environment, are you seeing a little bit more impetus from customers to want to consolidate to a converged security networking platform like Fortinet? And then for Keith, if you’re seeing any weakness, let’s say, elongating negotiating cycles and whatnot? Is it more weighted towards the core platform FortiGate side or the platform extension side, which is in access points?

It’s a very good question. Definitely, we see the convergence between networking and security; also, the pandemic accelerated this kind of change, especially inside the company, campus network, and work from remote anywhere. So that’s where we see that pretty strong growth. Also, a lot of connected devices like in the OT space; we see very strong growth. Like we mentioned, SD-WAN grew 60%, and OT grew 75%. We’re still keeping growth and gaining market share there. At the same time, we’re also expanding our network security beyond just the network, with end points, the cloud, and all other application levels from email and web, working together. We do believe the convergence and consolidation will benefit Fortinet for multiple years going forward; it’s a long-term growth driver for us.

Yes. To Hamza’s question, the speculation about where the larger or the timing comes in is correct, and that it’s going to be in the third of our business that is large enterprise. One, the dollars are larger, obviously. Customers spend a little more time with the ROI. But I think more importantly—on your second point, the question of adding in more of the platform products into a deal, you’re perhaps a little more likely to run into additional competitors or people internally that are champions of those competitors. So, there’s a little more that takes to get across the finish line because they are more complex in that way. As a reminder, we did 122 deals over $1 million in the quarter, which is a pretty fantastic number for us.

So, Keith, I know you hit on this once or twice already, but I just want to make sure I understand a dynamic on the services billings. If I back out product revenue from short-term billings, it looks like the annual recurring component of billings actually accelerated pretty nicely. I’m calculating like a 29% in Q1, improving to 40% in Q2. I don’t need you to bless the numbers, but directionally, does that seem right to you? And then, if so, how much of that was driven by pricing dynamics that you talked about versus just the natural cadence of the business?

I do think your math is directionally correct, but it’s a lot for more time to get anything more about how actually it may or may not be because I’m looking at it from a different perspective. Pricing actions generally appear fairly quickly on product revenue and billings, whether it’s product or service items. You will see it there. But on service revenue, you won’t see that benefit for an extended period of time. And I think one thing that may help people—if you recollect our shift from 8 by 5 support to 24 by 7 support. We talked about that for several years because when we turned off the 8 by 5 support, with that came a price lift. The mix had to evolve over time as you go through the sale. Price increases for service revenue is just another flavor of the same thing. You’re going to see the benefit over a much longer period of time on the service revenue line. You will see the benefit in billings much sooner, and that’s why we provided that information earlier, and you’re looking at it; you’re observing a leading indicator of where service revenue growth is going to go in the future. Okay. That’s really helpful. And then, just a real quick follow-up. You mentioned a $25 million headwind on service revenue from Russia, which is a new headwind. Does that apply to billings as well, or was that purely a revenue dynamic? That was a revenue dynamic, and I would probably say 30% to 50% of that would have been a billings dynamic in terms of where we were from the beginning of the year to where we’ll end up now.

On your platform extension, cloud security capabilities. I’m curious about the type of customer profile that’s interested there. I suspect they’re probably an existing Fortinet customer that’s transitioning to the cloud. I’m also curious if there are any fabric mesh. Can you talk about the characteristics of the people that are going down?

We do see the cloud security growing well, pretty much on a similar pace as other networking appliance growth. A lot of cloud security comes from the service providers, especially carriers, someone also combined with an offer SD-WAN and some also with OT. We keep saying for better security, to secure the whole infrastructure, not just the cloud; but also the appliances and some other product infrastructure. We see more and more customers want to consider overall together. Cost security also drives a lot of other parts of cybersecurity, other parts of infrastructure for cybersecurity. We do believe long-term that the service provider will play a very, very important role in security, especially in the service part. That’s where we want to keep supporting them. We see a more hybrid environment going forward and especially with more devices connected, so the whole infrastructure security more and more important.

I’d like to ask about your backlog, which has significantly and consistently increased for each of the last three quarters. It’s dramatically above year-ago levels. Keith, you made it clear that the backlog should further rise by year-end, which is great. But at the same time, it’s not going to grow forever. It’s common to see dips in the company’s backlog due to seasonality, significant order shipments, cancellations, etc. And so, it would just be helpful to get your sense of perhaps when we begin to see ebbs and flows in the backlog metric. If you could offer anything there, that would be helpful.

When supply chain is going to get better. So, I’ll let you handle that one.

If you compare to the end of Q1, we increased backlog by $120-some million. At the end of Q2, we increased about $72 million. There is some kind of improvement on increased backlog. We put a lot of effort into sourcing different parts or different vendor-designed products. The product line is fairly broad right now. I believe the demand is still very strong, so we expect to keep improving. We probably won’t expect backlog will reduce in Q3, Q4, but the increase will be less each quarter, probably. Next year, we will start to see some improvement within the backlog. Our engineering effort and the kind of the investment we’ve made in operation and manufacturing lead us to believe we can improve a little better now.

I think it was a logical place to have questions, and Ken’s comments are great. I would just add to that, keep in mind, this is why we provide some of the metrics there. There’s not major airplane orders, right? These are relatively small dollar items compared to what you may see in other industries. That’s why we provided some of the metrics on the size, if you will, and the fact that they’re existing customers and many of those have been partially fulfilled. We all have the same concern, and so, how do you get comfortable that that backlog is sticky and it’s going to be here when the product and supply chain loosens up? We’re giving those metrics for people to get some sort of context. Keep in mind these are comparatively to other industries; construction industry, airline industry; what have you, these are very small dollar amounts.

The age of our backlog is probably much better than our competitors. Like Keith mentioned, in the last two to three quarters, we’ve been able to fulfill over 60% of previous quarter backlog, which keeps our age in the backlog relatively short compared to most other competitors, sometimes they may take 1 to 2 years to deliver. This gives us a good position for customer trust during this supply chain issue. We offer quite a broad product; there’s always some alternative products we can suggest to customers if there are one or two that are in shortage. I believe we deliver over 90% of any booking in every quarter.

Congrats on another great quarter. I had a question on free cash flow. So I think you said you expect the low-end supply appliances to dramatically improve in Q3. Is there a margin or free cash flow impact that mix shift in Q3? And then related to that, given the shortfall on services that we saw in Q2 and the negative impact it had on your free cash flow, should we expect free cash flow to rebound in Q3 and Q4, or are you assuming the linearity remains unchanged in those quarters? Thanks.

Yes. I’m assuming the linearity is—don’t really have any reason to think that’s going to be any different. I’m looking for a reason to find, but I certainly have not found one yet. When we look at what our expectations are internally, we don’t guide to free cash flow; we’re trying to provide information that is helpful to others. I would assume that—I have no reason to assume anything other than we’ll still see more of the same, if you will. And then I think the first part of your question was you asked about low-end and about margin. In general, the margins increase from the entry level to the higher end of the product. So, from that aspect, and that’s why the comment in the script that there can be gross margin volatility both from the pricing actions we’ve taken and the discounting as well, but also the mix of our product. In a quarter that we see a higher mix of higher-end firewall shipments, margins will be higher by definition.

Keith, I was curious just to go back to the backlog for a second. You had mentioned the split being about 50-50 between FortiGate and networking portfolio. Just wondering if you could talk about how you expect that mix to trend through the end of the year? And I guess, the follow-up to that is what you’re seeing around the supply constraints between those two product portfolios?

Yes, I might double check the numbers. I think it was 50%, 50-40 between FortiGate and networking equipment. I have it backwards. Networking equipment is 50% and firewalls 40% and then cash and dollars the remainder of it. I think everything that we’ve seen to read in here can probably know more; the pressure certainly seems to be more intense on switches and access points than it does on firewalls. For a lot of reasons, I think we’re more successful with firewalls.

Yes, I agree. Probably, direction-wise, we do see the FortiGate inventory improving. So probably the percentage will shift a little bit more towards the switching and AP side, which is where the whole industry is suffering some supply issues, because we are more able to redesign and also use our own ASIC, which is also helping to reduce the backlog and keep supplies on time for the customer. But from the beginning of this backlog issue almost a year ago, definitely, we see the shifting a little bit more towards the networking side having a longer backlog.

I would now like to turn it back to Peter Salkowski. Thank you, Hope. I’d like to thank everyone for joining the call today. Fortinet will be attending investor conferences hosted by KeyBanc, Citibank, Evercore, Stifel, and Goldman Sachs during the third quarter. Fireside chats will be available through our IR website. Please let me know if you have any follow-up questions, feel free to contact me and have a great rest of your day. Thank you very much.

Thank you for your participation in today’s conference. This does conclude the program. You may now disconnect.