Fortinet, Inc. Q3 FY2022 Earnings Call

Fortinet’s Third Quarter Earnings Conference Call. At this time, all participants are in 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. Without further ado, I will now hand the conference over to your first speaker, Peter Salkowski, Vice President of Investor Relations at Fortinet. Peter, please go ahead. Thank you, Eric. Good afternoon, everyone. This is Pete Salkowski, Vice President of Investor Relations at Fortinet. I am pleased to welcome everyone to our call to discuss Fortinet’s fiscal results for the third quarter of 2022. Speakers on today’s call are Ken Xie, Fortinet’s Founder, Chairman, and CEO; and Keith Jensen, our Chief Financial Officer. It’s a live call that will be available for replay via webcast on our Investor Relations website. Ken will begin today’s call by providing a high-level perspective on our business, then follow up with a review of our financial and operating results for the third quarter, providing guidance for the fourth quarter and 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 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 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 our 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. Ken and Keith’s prepared remarks will be posted on the quarterly earnings section of the Investor Relations website immediately following today’s call. 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 third quarter 2022 results. Revenue for the quarter grew 33%, significantly outpacing the industry growth rate. We believe that customer recognition of the exceptional value proposition we provide through our high-performance Forti-ASIC technology and integrated FortiOS operating system is driving our ability to take cybersecurity market share. Product revenue growth was very strong at 39%, extending our position as a product revenue leader in the cybersecurity industry. Our product revenue performance reflects the strong demand we have built over the past 18 months across our security solutions along with the successful execution of our internal teams in managing supply chain challenges. Three growth drivers, the heightened threat environment, the convergence of security and networking, and the consolidation of security functionality among vendors, together with the opportunity to upsell additional security services to our significant installed base, are expected to drive future growth. First, the threat landscape, including ransomware, continues to expand and evolve, targeting companies of all sizes, locations, and industries. To counter the threat landscape, we are implementing our unique Universal ZTNA across a wide range of customers, driving triple-digit growth for this product and delivering a comprehensive approach to zero trust that is consistent for any user, anywhere, on any device, and supporting today’s hybrid workforce. Second, for years, Fortinet has led strategies around the convergence of networking and security. We estimate the total addressable market for networking and security will increase from $54 billion today to $73 billion in 2026. Convergence accelerates digital transformation and substantially reduces operational costs by combining networking modernization with dynamic security that seamlessly spans every part of the network, especially now that many companies are merging SOC and NOC operations together. Fortinet is leading the convergence trend with a wide range of technologies including Network Firewall and Segmentation, Secure SD-WAN, OT Security, and 5G in a single operating system which can be deployed as hardware, software, cloud, and as a service. Fortinet continues to gain Secure SD-WAN market share as our integrated Secure SD-WAN solution delivers better security, performance, and efficiencies over more traditional offerings. In the quarter, SD-WAN and OT bookings grew over 45% and 75% respectively, and together accounted for over 25% of total bookings. We believe we can achieve number one market share in SD-WAN in the next couple of years. Today, we announced the FortiGate 1000F, our latest innovation in converging networking and security. Powered by our new NP7 SPU, the 1000F delivers 5 to 10 times higher performance across six major network security functions while consuming 80% less power versus competitive solutions. The lower power consumption was a contributing factor in our top 2% ranking in the S&P Global Corporate Sustainability Assessment. Our third growth driver is the consolidation of vendors and product functionality. With Forti-ASIC’s huge computing power advantage, FortiOS can integrate more security functions than our competitors, together with over 30 key products ranging from endpoint to network to cloud security. Fortinet provides our customers with easier operation while lowering management costs and the total cost of ownership. Additionally, we are very focused on upselling value-added security services to our significant customer base. According to IDC’s second-quarter unit share data, Fortinet holds a number one market share position for units shipped at 43%, up 210 basis points. We expect to reach 50% market share in the next few years. This leadership position and the substantial installed base create attractive economies of scale and the opportunity to upsell additional security services. Before turning the call over to Keith, I would like to thank our employees, customers, partners, and suppliers worldwide for their continued support and hard work. Keith?

All right. Thank you, Ken, and good afternoon, everyone. Let’s start with an overview of our strong third quarter performance. Revenue of $1.15 billion was another quarterly record for Fortinet, increasing 33% year-over-year and 12% sequentially; our highest third quarter sequential growth rate in eleven years. We continue to deliver better than industry average top-line growth and generate strong profitability. Our operating margin exceeded guidance at over 28%, driving the adjusted free cash flow margin to 40%. Our history as a public company has revolved around the Rule of 40, measured as the combined total of revenue growth and operating margin. Impressively, the Q3 total came in at over 60. We continue to see success in our strategy for expanding further into the large enterprise segment. The number of deals over $1 million increased over 80% to 153 deals. The total billings value of deals over $1 million more than doubled, driven by a record number of deals over $5 million, and G2000 bookings increased over 40%. Our strong third quarter results reflect solid customer demand across both our Core and Enhanced Platform Technologies and the exceptional performance of the team in a challenging supply chain environment. We believe the investments we’ve made in building our platform and our go-to-market engine enable our customers’ digital transformation journey. Our platform strategy allows customers to converge networking functionality with security capabilities while consolidating cybersecurity products, providing security across their entire digital infrastructure while lowering their operating costs. Recently, the Forrester Wave Enterprise Firewalls report acknowledged the success of our investment strategy, placing Fortinet as a leader for the first time in its history. According to Forrester, “Fortinet excels at performance for value and offers a wide array of adjacent services. Long known for its bang-for-the-buck approach to network security, Fortinet has built a flexible and capable platform with its flagship product, the FortiGate Firewall.” Taking a closer look at the income statement, product revenue grew 39%. Product revenue growth for our Core and Enhanced Platform Technology products increased 29% and 51% respectively. The product revenue growth rate accelerated over 4 points sequentially, especially impressive given it is our toughest year-over-year comparison in over 10 years. Service revenue was up 28%, accelerating 3 points sequentially, driven by strong product revenue growth and seven consecutive quarters of increasing our term deferred revenue growth rates. Support and related service revenue was up 28%, accelerating over 2 points sequentially to $311 million. While security subscription service revenue was up 29%, accelerating 4 points sequentially to $370 million. Total revenue in the Americas increased 34%. EMEA revenue increased 37%, and APAC posted revenue growth of 23%. Total gross margin at 76.2% exceeded the high end of our guidance range. Product gross margin of 61% was up 30 basis points year-over-year. Services gross margin of 86.6% was flat year-over-year, but up 70 basis points sequentially. Operating margin of 28.3% was up 250 basis points, benefiting from FX and the operating margin leverage that comes with higher revenues. Shifting to billings. Billings of $1.4 billion were up 33%, representing the sixth consecutive quarter of billings growth in excess of 30%. Core platform billings were up 27% and accounted for 67% of total billings. As shown on Slide 6, our entry-level FortiGates posted very strong billings growth with the mix shifting 16 points in their favor, driven by demand and, as we expected, improved supply. Enhanced platform technology billings were up 45% and accounted for 33% of total billings, a positive mix shift of 3 points. Average contract term was flat year-over-year at 29 months. Looking at the statement of cash flow summarized on Slide 7 and 8, free cash flow was $395 million. Adjusted free cash flow, which excludes real estate investments, was $464 million, representing a 40% adjusted free cash flow margin. DSOs were down five days sequentially while increasing 12 days year-over-year to 75 days. Cash taxes were $69 million. Capital expenditures were $88 million, including $69 million for real estate investments. We repurchased 10.2 million shares of our common stock for a cost of $500 million, bringing the year-to-date totals to 36 million shares at a total cost of $2 billion. The remaining repurchase authorization totals $530 million. Regarding backlog, the backlog at the end of the third quarter was up slightly from the end of the prior quarter, with FortiGate Firewalls accounting for just one-third of total backlog. We expect fourth quarter ending backlog to be relatively consistent with the third quarter backlog as we are seeing early signs of a transition back to more normalized customer buying behaviors. Moving to guidance. The current environment favors a Fortinet style platform that offers integrated solutions and strong security capabilities for an attractive cost of ownership. To enhance our ability to capture our share of the large market opportunity, we plan to continue to invest in innovation across our integrated platform offerings. Now I’d like to review our outlook for the fourth quarter summarized on Slide 9, which is subject to disclaimers regarding forward-looking information that Peter provided at the beginning of the call. As part of the Q4 guidance setting process, we considered several factors, including the greater macro uncertainty today and with it, the increased risk of forecasting the timing of certain larger transactions. The transition to more normalized customer buying behaviors, which means there is less of an emphasis on ordering to secure a place in line. For comparison, in the fourth quarter of 2021, when supply was tighter, backlog increased over $120 million and contributed to 49% bookings growth. Additionally, elevated early-year top line comparisons include certain one-time items adding a couple of points of service revenue growth and fully cycling the Alaxala acquisition. In response, we have slightly widened our top-line guidance ranges. For the fourth quarter, we expect to again reach the Rule of 60. The key metrics include billings in the range of $1.665 billion to $1.720 billion, representing growth of 30%. Revenue in the range of $1.275 billion to $1.315 billion, which represents growth of 34%. Non-GAAP gross margin of 75% to 76%, non-GAAP operating margin of 30% to 31%, non-GAAP earnings per share of $0.38 to $0.40, which assumes a share count of between $795 million and $805 million. We expect capital expenditures of $75 million to $85 million. We expect a non-GAAP tax rate of 17%. For the full year, we expect billings and revenue growth to exceed 30% for the second consecutive year: billings in the range of $5.540 billion to $5.595 billion, which at the midpoint represents 33%, revenue in the range of $4.410 billion to $4.450 billion, which represents growth of 33%. At the midpoint, these full-year billings and revenue growth rates are 3 points higher than the initial growth rates we provided in early February, despite the start of the war in Ukraine in late February, significant increases in interest rates, and increasing uncertainties in the macro environment. Full-year backlog is expected to be above the February estimate of $350 million. Total service revenue in the range of $2.645 billion to $2.655 billion represents growth of 27% and implies full-year product revenue growth of 42%. Non-GAAP gross margin of 75% to 76%; non-GAAP operating margin of 26% to 27%, at the midpoint a year-over-year increase of 30 basis points. Higher midpoint gross and operating margin expectations were 50 and 100 basis points above the February guide, respectively. Non-GAAP earnings per share of $1.13 to $1.15, which assumes a share count of between $800 million and $810 million. We expect full-year capital expenditures of $325 million to $335 million. We expect our non-GAAP tax rate to be 17%. We expect cash taxes to be $265 million. Before wrapping up, I’d like to offer some preliminary thoughts on 2023 and our midterm targets following a very strong set of growth in 2021 and in 2022. We continue to successfully balance growth and profitability while investing in longer-term innovation and go-to-market initiatives to ensure future growth. The strength of our business model includes diversification, margins that provide capacity for future investment, and a rich mix of higher-margin recurring service revenues. As we saw in the highs of the pandemic, diversification helps mitigate the risk of economic slowdowns. Specifically, in 2020, we delivered operating margins of nearly 27%, adjusted free cash flow margin of over 38%, and top-line growth of 20%. In the past 12 months, we have exceeded our target operating margin targets while increasing our engineering headcount by about 20% and significantly increasing our future sales capacity by over 25%, including a greater than 50% increase in new, non-tenured salespeople. While we will provide more detailed 2023 guidance when we report our fourth-quarter results, it’s worth noting that service revenue accounts for 60% of total revenue, with gross margins hovering above 85%. We see continued service revenue growth driven by two years of very strong product revenue growth and seven consecutive quarters of accelerating short-term deferred revenue growth. With a strong business model and a history of execution, we are confident that our momentum will continue and point to our key growth drivers, including strategic investments, the heightened threat environment, the convergence of networking and security, and cybersecurity consolidation. Cybersecurity is not immune to economic slowdowns and is expected to remain a relatively safe harbor. As such, we remain on track to achieve all of our medium-term financial targets from our May 2022 Analyst Day, including $10 billion in billings and $8 billion in revenue in 2025, each representing a 22% three-year CAGR from the midpoint of our 2022 guidance. The targets also included an average non-GAAP operating margin of at least 25% for the four years from 2022 to 2025 and a 2025 adjusted free cash flow margin in the mid-to-high 30% range. Illustrating our long-term focus for balancing growth and profitability, our targets remain committed to the Rule of 40 or better. I’ll now hand the call back over to Peter to begin the Q&A.

Thank you, Keith. Eric, we are now ready for Q&A.

And our first question comes from Fatima Boolani at Citi. Fatima, your line is open.

Thank you. Good afternoon. I appreciate you taking my questions. Keith, this one’s for you, just with respect to the 4Q guidance and the outlook. I appreciate you kind of breaking down the three principal factors that went into that. But I wanted to dig in specifically on the comment you made about normalized buying behavior as it relates to the backlog build. So I think what I inferred from your comments is that while the backlog is going to be sequentially up and sort of higher than what you initially pointed out to be maybe $350 million of ending backlog. That’s certainly below the $500 million that you were previously telegraphing. So I just wanted to better understand sort of the modulation downward on backlog there and how the sort of normalized buying behavior contributes to that? And then I’ll ask my follow-up.

Okay. I think when we talk about normalized buying behavior, certainly, we saw some enterprise customers in the U.S. during the supply chain challenges. They were placing orders to get in line to hold their place in line for when the inventory is available. A year ago, that was an appropriate behavior when there was a lot of uncertainty around the supply chain and maybe they were planning what to do in 2022. I think that somewhat in general now, and maybe Ken will talk more about this, people are getting the sense that the supply chain is a little bit easier to forecast and somewhat easier to manage. I don’t mean by any stretch that it’s easy, but I do think it’s easier. With that, we’re starting to see the market drift back towards the emphasis on what I would call more traditional buying, which is when they need it, they’re placing the order.

Looking at the composition of our backlog, it’s only one-third or less related to our network security platform FortiGate; more than half is related to switches and access points, which are networking equipment issues within the industry. Networking devices tend to be more changeable and standard-driven. Many customers, sometimes double or triple order to get ahead of whatever the supply chain issue is, and some of them can easily cancel once they receive the product. That’s why we feel tracking the backlog may not be the best way to forecast the business; we should be more focused on security functionality, particularly driving future service based on our significant FortiGate installation base.

Thank you. And Keith, just a clarification on the services revenue trajectory and more broadly thinking about next year. So we saw the reacceleration this quarter in services revenue. I wonder if you could give us a quick update on how the delayed registrations from earlier in the year and transactions from earlier in the year are trending and how we should think about that filtering and flowing into our models for next year? Thank you.

Yes. I think we’ve been messaging throughout the quarter at various conferences that – and even in the prior quarter that we had a clear expectation that service revenue growth would accelerate, so we’re very pleased to see that. A number of things are providing a tailwind into that. Customer registrations are part of that story. Also, the price increases are making their way first into orders and deferred revenue, and now into the income statement. Keep in mind that we have contracts that last sometimes as long as five years, which will give you a sense of how long the tailwind may relate to price increases as we continue to cycle through renewals at old prices and replace them with new contracts. We feel good about the direction of service revenue and the margins it provides, together with the fact that it’s 60% of our business.

Thank you. Our next question comes from Saket Kalia at Barclays. Saket, your line is open. Please go ahead.

Okay. Great. Thanks very much for taking my question here. Keith, maybe just to start with you. I’d love to just zero in on product revenue growth a little bit for this year. Can you just maybe talk about some of the growth drivers for product revenue this year that aren’t expected to repeat next year? Again, very helpful detail in thinking about total billings for the following years. But for product, what are some of the one-off things that we should be keeping in mind, like the Alaxala acquisition and price adjustments, to sort of think about what normalized growth in product might look like as we start to think about the following years?

Yes. I think Alaxala is probably the easiest one to talk about in terms of providing numbers. Their revenue stream was probably in the order of $130 million to $140 million when we acquired them and reminded people that they are a March 31 year-end, so their fourth quarter is a little bit off cycle. I think that growth will be single digits. That probably gives people a good level of expectation reminder. Our interest in Alaxala focuses on the IP and some long-term opportunities we have there. Regarding other unique factors about product revenue in the quarter, as the backlog comes into revenue as we go through the end of 2022 and into 2023, it will provide a tailwind for what product revenue growth looks like in 2023.

We believe the growth driver, especially with the converged network and security, won’t slow down. This will continue to drive product revenue growth in the next 5 to 10 years. The secure SD-WAN and OT both have shown robust growth. We expect to see continued growth fueled by a significant market potential.

Got it. Got it. Maybe for my follow-up, really for both of you, I’ll make a jump ball here. I think in Q3, we had operating margins of about 28%. I think the guide for Q4 is for margins a little bit higher. When I think that long-term guide out to 25% at least, it feels like you’re doing a lot better than that here in the near-term. Maybe the question is, how do you sort of think about that balance regarding growth, maybe moderating or normalizing as we mentioned versus that long-term margin?

If you look at the 13-year history of us as a public company, we have always balanced growth with margin. We feel that 25% operating margin is healthy, and we can provide funds for growth to become a leader in the space. That's why we keep saying the Rule of 40; in the last few quarters, we even reached the Rule of 60. When growth slows down, that helps improve margin. We do expect growth to continue in the next few years with the three growth drivers I mentioned, plus additional service revenue from our large installation base.

I certainly agree with Ken. It’s important to remember that we sell in U.S. dollars, so there’s not a direct FX impact there on the revenue line. However, in certain countries, pressure on discounting can arise due to exchange rates. But we benefit from the strength of the U.S. dollar in operational spending, which can contribute to our margins as well.

Okay. Our next question comes from Hamza Fodderwala at Morgan Stanley. Hamza, your line is open. Please go ahead.

Hi, good evening. Thank you for taking my question. Keith, on the backlog, I appreciate that sometimes too many metrics create noise. On the supply chain front, it seems like it’s getting a bit clearer. Could you give us any more granularity on how that backlog and booking trajectory looked relative to your guidance? When you guided to it, you were saying about 36% growth at the midpoint for bookings. Just curious how that shook out in Q3.

Yes. When we introduced the backlog metric a year ago, there was a lot of uncertainty regarding the supply chain crisis and its impact on our business. The purpose of providing the backlog disclosure then was to give investors insights into our business model as we go forward. Earlier we estimated backlog growth to be around $350 million in Q1 and then $500 million for the full year, but now we are looking at a number that may be less than that. Net-net, we have become much more comfortable with our ability to execute in this environment. It’s time we feel that we have gotten a better control on it to align ourselves more with what our industry competitors disclose.

Makes total sense. Just to follow up really quickly. Is it fair to say that your bookings growth is still higher than your billings growth? Obviously, your backlog grew. So you’re still expecting underlying bookings to be higher than 30% this year?

Yes, we’re not going down to the detail of talking specifically about bookings, as I just mentioned, from our backlog, more than what we’ve provided to this point.

Okay. Our next question comes from Rob Owens at Piper Sandler. Rob, your line is open. Please go ahead.

Great. Good evening. Thanks for taking the question. Just one from curious with the supply chain getting a little bit easier. How are you thinking about gross margin, both in the short term as well as the medium term?

I think the components and costs continue to rise. We still have fairly tight inventory, which leads to making most shipments by air instead of by ocean. We’ll have to adjust based on these costs and may raise prices, but we feel that even with price increases, we maintain a price advantage compared to industry averages with our products. Margins are likely to stabilize overall as supply improves.

Ken is spot on with that. If we look between product gross margin and services gross margin, it's the product side that tends to be more volatile. We've heard commentary that things may be easing a bit with chip manufacturers, but there have been no indications of cost reductions coming from suppliers. Therefore, we will monitor how that plays out. Our strategy has been to raise prices gradually while passing along most but not all of the price increases, with a goal of maintaining healthy margins.

Okay. Our next question comes from Shaul Eyal at Cowen. Shaul, your line is open. Please go ahead.

Thank you so much. Good afternoon, guys. Keith, I have a question on APAC; you reported the softest performance in I think like two years. What was driving that? And I have a follow-up.

Yes. We made a leadership change there around the end of June, beginning of July with a retirement. I think that the transition of leaders did impact performance. That said, we feel very good about the new leadership’s abilities. I think the other factor is that you’re starting to see the lap effect of Alaxala because all of Alaxala is sitting in APAC and this will roll up the full quarter comparisons that impact performance.

Understood. And on FortiGate sales, looking at it from a tier perspective, it was slightly more mixed than prior quarters, with entry-level actually representing most growth versus the mid-range and high end. Any color on that front?

We see pretty strong growth related to the SD-WAN and OT, which are more reliant on lower-end unit sales. The supply chain improvements have also allowed us to ship more product in the low-end range. We still have some backlog in the mid and high-end, but we have seen improvements in the low-end due to redesigning some products and an overall better supply chain right now.

Ken mentioned our entry-level FortiGates in particular; we were somewhat constrained in Q2 and the beginning of Q3, but the low-end supply availability increased significantly in the third quarter, which is a factor of demand exceeding supply in some ways.

Okay. We are connecting the next caller now. Brad Zelnick from Deutsche Bank. Brad, your line is live.

Thank you so much, and thank you for taking the questions. Ken, just a big picture question for you to start out. You mentioned Fortinet's success is in part coming from the industry trend of vendor and product consolidation. Why is Fortinet so well positioned as a platform for consolidation? How does this inform your product and corporate development roadmap regarding the need for broader product functionality to compete effectively with other platform competitors?

We have several unique advantages. First, from day one, we developed FortiASIC, which provides huge computing power compared to traditional CPUs. FortiASIC works side by side with the CPU. This huge compounding power allows FortiOS to run more security and networking functions than our competitors, which is an advantage that none of our competitors can match. This drives market share growth and our unit shipments; we now hold 43% market share for units shipped. Second, our FortiOS integrates more functions leveraging security and network capabilities. We have about 30 different home-developed products that integrate, automating together, which helps drive lower management costs and total cost of ownership for customers. These factors strengthen our position for consolidation both in product functionality and across different products in a single vendor platform strategy.

Ken, thank you for that. I think it's clearly working with your strategy as you build on it. Maybe Keith, just for you, you’ve disclosed quite a bit of information so much so that I have a very simple question that I might have missed, but can you just very clearly explain the reduction in the full-year billings guidance based on these results?

Yes, I think that you’re referring to full-year fourth-quarter guidance at this point. I would point to the macro environment and what we’ve seen over the last 90 days in terms of economic activity. I think when you look at how that manifests somewhat specifically, appropriate caution emerges regarding forecasting close timing on some larger deals. We’ve been successful in the past few years, but the deals have become significantly larger as we’ve gone forward, and it seems right to be somewhat cautious on our close rates. The business itself is very healthy; the small enterprise portion of the business, for example, actually outgrew the other segments by approximately one point in the last quarter.

It makes total sense and aligns with a lot of other data points we’re seeing out there. Just as you consider this, is there any risk of customers shrinking deal sizes or taking longer to make decisions, or is it primarily a macroeconomic issue?

I don't anticipate seeing deal sizes shrink; as we move further into the enterprise segment, we expect average deal sizes to grow. The concern is more about corporate America and the rest of the world going through budgeting cycles, considering what they plan for 2022’s end and 2023. Now isn’t the optimal time for significant budget flush in Q4; if it develops, that would be fantastic, but caution seems more appropriate here.

Okay. We’re just lining up our next caller. Our next caller is Shrenik Kothari from Robert Baird. Your line is open. Thank you.

Thank you.

Okay. We will move on to the next question. Please standby. Tal Liani at Bank of America. Tal, your line is open.

Hi, here is Madeline on for Tal today. Just two quick ones for me, and I apologize if this has already been mentioned. But just to be direct, last quarter, we heard bookings were a little softer than expected. This quarter, there's no disclosure on bookings again. I apologize if this was already mentioned, but can I get clarity from you, Keith, as to why there’s no bookings this quarter after a weaker quarter last time?

Yes. We discussed this internally before the call. When we got into this discussion last year, we felt that backlog was important for investors, but now we feel more confident about executing in this environment. So it's time to align ourselves back with industry norms, where others typically don't disclose this information. Our cancellation rate has been consistent at around 4% each quarter.

The composition of backlog has also changed significantly. A year ago, it was mostly related to FortiGate, and now it’s less than one-third related to network security and more related to switches and access points, which have more volatility because customers can switch vendors easily in networking compared to the switching costs involved with security products.

Got it. Thanks so much. Just one follow-up question. On the visibility side, are you seeing less visibility compared to before, or is it the same? Can you provide some commentary on trends you’re observing in the pipeline?

I think the pipeline visibility is very good, and we are seeing very strong pipeline growth. We reiterated our mid-term guidance numbers, including $10 billion in billings by 2025 and $8 billion in revenue, basically reiterating that we are doing this with a very strong pipeline and momentum.

Okay. Getting ready for our next caller. The next caller is Keith Bachman at BMO. Keith, your line is open. Please go ahead.

Many thanks. I also had two for Keith. I wanted to go back to the billings commentary for Q4. Just on the revenue base, it’s essentially the same, and therefore, it’s the DR impact that you’re guiding lower. As you mentioned that you’re expecting backlog to be less than the $500 million you previously suggested, has some of that backlog flowed into the billings?

Yes. I want to be clear: we expect backlog to actually increase from Q3 to Q4, not significantly, but slightly. So, none of the backlog is flowing into billings as anticipated. As for Europe, I can say the billings numbers there performed very well in the quarter, and their pipeline remains strong. While we will see some headwinds as we approach 2023, Europe has executed very well.

If you look at Europe, we do see opportunities for growth in the year 2023. We could see momentum in larger deals, particularly as we continue to consolidate operations, which can help the business remain competitive.

Okay. We are just pulling up our next caller and it’s Gregg Moskowitz from Mizuho. Gregg, please go ahead. Your line is open.

Okay. Thank you for taking the questions. Keith, I know you had experienced a bit of a pause in the first 10 days of June. With that in mind, how was linearity in the Q3 period? Were there any air pockets or anything that you would call out?

Yes. We didn’t see anything like we did in June’s first part. I think that you can see this reflected in our DSOs; it’s a good reflection of where we’re at with linearity. It has not, and may never be, a 1/3, 1/3, 1/3 business in linearity. About 50% of business typically occurs in the final month of each quarter, but nothing unusual happens regarding activity.

Okay, thanks. And just as a follow-up, we’re getting quite a few questions about that billings guidance for Q4. You outlined earlier some of the cash issues going into that guidance, along with concerns on elongation of sales cycles. I do want to be fair, though, on that point. Are you seeing any changes as it relates to average sales cycle over the past three to four months?

We still have a very strong pipeline, actually stronger than before, and we built pretty healthy sales capacity to meet the demand. Keith mentioned some tenure; we have about 50% of our sales force that is less than tenured, but this increase will provide stronger productivity in the next 6 months to a year, which will help support both our top and bottom line.

To add detail, we’ve increased our people; about 30% of the mix and that’s a significant number of people who have increased but are new to the organization. That will play a role in sales as we move forward.

Standby for our next question. Adam Tindle at Raymond James is our next caller. Adam, your line is open. Please go ahead.

Okay. Thanks. Good afternoon. Keith, I wanted to start to appreciate that you gave a little bit of color on 2023 on services growth acceleration. Obviously, it’s exciting. Conversely, I think the flip side of that is we're unsure how to think about the puts and takes to product revenue growth. Not asking for specific guidance, but I’m referencing these tough comps. You just had very strong growth in Q3 from one of the toughest comps we’ve ever seen. Your exit rate billings guidance is down, and there’s concern that cancellation rates are at 4%, but might ultimately increase as supply chain visibility improves. How bad could product revenue growth ultimately be? Certainty around service revenue growth is unlike before. Anything you could point us to for a realistic view on how to think about product revenue growth in 2023?

The growth driver has not changed. The convergence and the consolidation within security and networking, along with an elevated threat environment, will keep driving product growth for the next 5 to 10 years.

The cancellation rate has remained remarkably consistent at around 4%, so I don’t see any indicators of concern regarding cancellations. Our backlog consists mainly of existing customers, and over 90% to 95% relates to them. As we watch this aging backlog, we have noticed some plateauing in increases alongside easing in the supply chain environment on the horizon.

The top 20 deals in backlog account for approximately 8% of total backlog. Overall, our operations remain stable, and we feel confident moving into the next quarter.

Okay. We have our last question for the session from Michael Turits at KeyBanc. Your line is open, Michael.

Thanks. Ken, can you talk about whether it's realistic for backlog to continue to rise after this quarter or if we are at a point where it starts to go down? Fundamentally, where do you think we are regarding demand and a refresh cycle around data centers that may have been neglected during COVID?

I think the key is that we have recently seen shifts in the network security landscape. We’re not necessarily relying on refresh cycles. Instead, the growth is coming from areas like the convergence of SD-WAN and operational technology. We anticipate this demand will drive growth for a significant period, more than five years.

I think it’s reasonable to state that we expect backlog to stabilize, and the demand remains strong. There are always fluctuations, but our strategic initiatives continue to place us in a strong position.

Thank you, Eric. I’d like to thank everyone for joining today’s call. Fortinet will be attending investor conferences hosted by Barclays, Stifel, and Wells Fargo during the fourth quarter. Fireside webcast links will be posted on the Events and Presentations section of our website. If you have any follow-up questions, please don’t hesitate to reach out. Thank you very much.

This concludes our program. You may now disconnect. Thank you.