Fortinet, Inc. Q4 FY2022 Earnings Call

Thank you for standing by, and welcome to the Fortinet Fourth Quarter Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. As a reminder, today's call is being recorded. I will now turn the conference to your host, Mr. Peter Salkowski, Senior Vice President of Finance and Investor Relations. Please go ahead.

Thank you, Valerie. Good afternoon, everyone. This is Peter Salkowski, Senior Vice President of Finance and Investor Relations at Fortinet. I'm pleased to welcome everyone to our call to discuss Fortinet's financial results for the full-year and fourth 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 and operating results for the full-year and fourth quarter of 2022 before providing guidance for the first quarter of 2023 and the full-year. We'll then open the call for questions. Before we begin, I'd like to remind everyone that on today's call, we will be making forward-looking statements, and these forward-looking statements are subject to risks and uncertainties, which could cause actual results to differ materially from those projected. Please refer to our SEC filings, in particular, the risk factors in our most recent Form 10-K and Form 10-Q for more information. All forward-looking statements reflect our opinions only as of the date of this presentation, and we undertake no obligation and specifically disclaim any obligation to update forward-looking statements. Also, all references to financial metrics that we make on today's call are non-GAAP unless stated otherwise. Our GAAP results and GAAP to non-GAAP reconciliations are located in 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 for today's earnings call will be posted on the quarterly earnings section of our Investor Relations website immediately following the 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 Xie.

Thanks, Peter, and thank you to everyone for joining today's call to review our outstanding full-year and fourth quarter 2022 results. For the full-year, revenue growth accelerated to 33%. We continue to gain market share in the service security industry with customers increasingly recognizing how Fortinet integrates a single platform approach to security delivering a lower total cost of ownership and a greater return on investment than competing solutions. Product revenue growth of 42% was very strong, making Fortinet a leading product revenue company in the cybersecurity industry with total product revenue of $1.8 billion. Our SD-WAN and OT bookings together accounted for over 25% of total bookings. Our goal is to keep growing and achieve #1 market share in network firewall, Secure SD-WAN, and OT security market over the next couple of years. For 20 years, Fortinet has made long-term strategies and investments around the convergence of networking and security. Yesterday, we announced our fifth-generation FortiSecurity processor, the FortiSP5. This new SoC base for the ASIC has secure computing power rating for major network security functions like Firewall, supporting 17x to 32x more than the average of our competitor’s similar price model using general purpose CPUs and doubles the ASIC chip acceleration of applications to Forti such as New Trust, SASE, 5G, and our SD-Branch with much better performance and efficiency. According to the most recent IDC data on unit shipments of firewall plants, Fortinet holds the #1 unit shipped market share position at 48%, providing Fortinet with an attractive economy of scale, positioning us well and making it difficult for competitors to develop their own ASIC technology due to high entry barriers and significant investments that are required. Fortinet's substantial installed base of product functions enables us to offer additional secure services, upsell, integrated and automated for the Fabric Product Solutions. We recently announced several new and advanced services that help SOC teams reduce their operations cyber-risk while being more efficient in handling cybersecurity issues. As networking and security continue to converge and consolidate, we believe we are well positioned to achieve our 2025 building target of $10 billion. 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.

Thank you, Ken, and good afternoon, everyone. As we look back at 2022, we see the success of our strategy to lead in convergence and consolidation as well as the combined power of our ASIC technology with our integrated operating system. Combined, these efforts are driving our strong financial results. There's been an explosion of devices that must be connected to the cloud, data center, and edge compute. As a result, the infrastructure has expanded to support secure connectivity via distributed firewalls; it is no longer feasible to overlay security on top of networking in the data center. They must be deployed as a converged solution. Firewalls need to work seamlessly with networking and security applications across the company’s entire infrastructure. Fortinet is leading the convergence trend with a wide range of technologies, including network firewalls, Secure SD-WAN, 5G, and OT security, all embedded in our single operating system delivered as hardware, software, cloud, and as a service. Traditional CPU-based solutions are very inefficient in supporting both networking and security. That's why Fortinet developed proprietary ASIC technology to build an application-specific solution. Yesterday, as Ken mentioned, we announced our next-generation ASIC, the FortiSecurity processor or FortiSP5, which allows line-speed convergence of networking and security at every network edge. The new seven-nanometer technology combines existing NP7 technology with new content processor capabilities. Our enhanced platform suite of integrated products is delivering on customer demands for convergence, vendor consolidation, ease of management, and lower operating costs. The success of this strategy is evident in our full-year 2022 results, and I'll start there. Billings passed the $5 billion mark, totaling $5.6 billion and growing 34%. While revenue totaled $4.4 billion, with growth accelerating to 32%, the fifth consecutive year of revenue growth of 20% or more. Driven by strong demand for our fabric and cloud security solutions, enhanced platform technology billings and revenue both increased over 40% to $1.8 billion and $1.5 billion, respectively. Despite a challenging global supply chain environment, product revenue growth came in at 42%, our highest annual product revenue growth rate in over 10 years. Our product revenue growth was driven by continued growth of our firewall use cases and the addition of over 23,000 new customers. Service revenue was up 26% to $2.6 billion, resulting in three consecutive years of accelerating service revenue growth rates. Gross margin was strong at 76.3%, and operating margin outpaced our initial expectations, increasing by 110 basis points to a new Fortinet record high of 27.3%. Our GAAP operating margin of 22% is one of the highest in the industry, and we continued our streak of being GAAP profitable every year of our 14-year history as a public company. Earnings per share increased 49% to $1.19. Free cash flow was a record at $1.45 billion. Free cash flow margin was 33%, and adjusted for real estate investments, the free cash flow margin came in at 37%. For the year, we repurchased approximately 36 million shares at a cost of $2 billion. Total deferred revenue increased 34% to $4.6 billion. Short-term deferred revenue increased 32% to $2.35 billion. Quarterly contract terms throughout the year were consistent with the year earlier periods, including the fourth quarter at 28 months. Before moving on to our Q4 results, I'd like to summarize our enterprise success and highlight a few seven-figure deals from 2022. We saw great success during the year with our strategy to expand further into the large enterprise segment as the number of deals over $1 million increased over 55% to a record 546 deals and billings on these deals increased by over 70%. If we look at a few of our large deals of the year, let's start with the competitive upsell deal; Fortinet displaced 11 different vendors by consolidating the customer's network to security functions on our Security Fabric. This worldwide wholesaler previously purchased secure SD-WAN and FortiProxy. Next on the list was a centralized network security solution that could be managed and deployed to its 400 global locations. This customer chose Fortinet Security Fabric for a selectable and integrated solution across multiple scenarios, including work from anywhere, perimeter security, and data center segmentation. In another upsell deal, a leading global manufacturer was spun off and had to stand up the security and networking infrastructure separately. The newly created infrastructures included remote access, SD-WAN, application delivery control, authentication, endpoint, email protection, and switching. Keys to our win included our Zero Trust capabilities, a cloud-first SD-WAN strategy, and the ease of integration and convergence across our platform suite. Lastly, in the new logo win, a large U.S. retailer with over 500 locations was struggling with a total cost of ownership of their legacy security architecture. Keys to this win included delivering a single pane of glass versus the multiple consoles they were using and replacing the competitors' firewalls with our FortiGates, delivering URL filtering, WiFi security, and edge router replacement, all on our unified and integrated FortiOS platform. This customer reported anticipated savings of $29 million over five years. Turning to Q4 results, both billings and revenue delivered new Fortinet records with billings of $1.7 billion and revenue of $1.3 billion. Both metrics increased over 30%. The strong fourth quarter revenue performance reflects solid customer demand across both our core and enhanced platform technologies. In the fourth quarter, we added over 6,200 new logos, another new Fortinet record reflecting the support of our channel partners, the leverage they bring, and the breadth of our worldwide customer base. Taking a closer look at the fourth quarter, billings growth of 32% was driven by a 40% increase in enhanced platform technology billings, which accounted for over one-third of total billings. Total revenue growth of 33% was driven by strong demand for core and enhanced technology platforms, which increased 26% and 47%, respectively. Product revenue grew 43% to $540 million. Service revenue was up 27% to $743 million, driven by strong product revenue growth and strength in our security subscriptions. Short-term deferred revenue grew 32% and represents eight consecutive quarters of accelerating growth rates. Total gross margin of 77.6% was driven by a 310 basis point increase in product gross margin to 65.2%. Several factors converged to drive our record high quarterly product gross margin, including legacy pricing actions, easing supply chain cost pressures, and improved discounting. Operating margin of 32.5% was up 400 basis points year-over-year due to the strong gross margin performance and FX benefits. Looking to the statement of cash flow summaries on Slides 11 and 12, free cash flow was $497 million, adjusted free cash flow, which excludes real estate investments was $510 million, representing a 40% adjusted free cash flow margin. Cash taxes were $63 million, capital expenditures were $31 million, including $13 million for real estate investments. DSO increased 14 days sequentially and year-over-year to 89 days, also impacting service revenue growth. Moving to guidance, we believe the continued innovations we made in building our platform enable our customers' digital transformation journey. As Ken noted, customers are increasingly recognizing how Fortinet’s integrated single platform approach to security can deliver a lower total cost of ownership and a greater return on investments than competing solutions. Now I'd like to review our outlook for 2023, summarized on Slide 15, which is subject to disclaimers regarding forward-looking information that Peter provided at the beginning of the call. For the first quarter, we expect billings in the range of $1.415 billion to $1.465 billion which at the midpoint represents growth of 24%. Revenue in the range of $1.180 billion to $1.220 billion, which at the midpoint represents growth of 26%. Non-GAAP gross margin of 75% to 76%; non-GAAP operating margin of 23% to 24%, which at the midpoint represents an increase of 150 basis points. Non-GAAP earnings per share of $0.27 to $0.29, which assumes a share count of between $795 million and $805 million, capital expenditures of $80 million to $110 million, non-GAAP tax rate of 17%, cash taxes of $20 million. I should also note that first quarter guidance assumes backlog decreases slightly during the quarter. For the full-year, we expect billings in the range of $6.710 billion to $6.790 billion, which at the midpoint represents growth of 21%. Revenue in the range of $5.370 billion to $5.430 billion which at the midpoint represents growth of 22%. Total service revenue in the range of $3.335 billion to $3.365 billion, which at the midpoint represents growth of 27% and implies a fourth consecutive year of accelerating service revenue growth. The service revenue guidance also implies product revenue growth of 15%. Non-GAAP gross margin of 75% to 76%, non-GAAP operating margin of 25% to 26%, non-GAAP earnings per share of $1.39 to $1.41, which assumes a share count of between $805 million and $815 million. Capital expenditures of $400 million to $450 million due to continued investments in cloud, data centers, and facilities. Non-GAAP tax rate of 17%, cash taxes of $375 million, split somewhat evenly between the first and second half of the year. The increase in cash taxes reflects recently effective R&D capitalization and amortization requirements. The full-year estimate assumes backlog approaches historical levels by the end of the year. Cybersecurity, although not immune to economic slowdowns, is expected to remain a comparatively safe harbor. With a strong business model and history of execution, we are confident that our market share gains will continue. We remain on track to achieve our 2025 financial targets, which include billings of $10 billion, revenue of $8 billion, non-GAAP operating margin of at least 25%, and adjusted free cash flow margin in the mid to high 30% range in 2025. With that, I'll now hand the call back over to Peter to begin the Q&A session.

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

Thank you. Our first question comes from Brian Essex of JPMorgan. Your line is open.

Great. Thank you. Good afternoon, and thank you for taking the question. Congrats on some solid results and a solid guide. Given that we heard from one of your peers last night, and they were markedly more conservative or cautious on the macro than you seem to be. Maybe for Ken and Keith, could you help us understand what you're seeing in the market from a macro perspective, how enterprises are spending? How do any changes in the quarter relative to initial expectations pan out with regard to demand? We're seeing sales cycles elongating and budget scrutiny ongoing. What are you seeing on your side?

I took a question feedback from some customer partners. Their budget is tight, but Fortinet solution has a better cost of ownership and also kind of even cost saving for some like a Secure SD-WAN solution. At the same time, we do see the use case of firewall expanding much broader than before, especially for this OT security and some other areas, which I'd say network security may be the only solution to secure some of this OT area. So that's where we see the demand is still pretty strong. We're likely to keep gaining more market share in this well-fragmented market.

Yes. Thanks, Ken. I spot-on with that. I would also add, look, I think we're all sensitive to the overhang from the macro environment and what that may mean. However, when we look at our internal numbers, whether it's pipeline growth, and even if we compare what pipeline growth is today versus a year ago, it's even up in terms of percentage growth rates. The use cases, and I think in this environment, the savings that we offer and the ROI that we provide, and some of the case studies that we provided in the call, there are examples of that. I think we're continuing to benefit from that, and we do see continued opportunities for market share gains even in this environment.

Got it. Maybe just for a quick follow-up then, Keith. As you think about the level of conservatism in your fiscal '23 guide, I mean, it's stronger than I think some had expected. I know I'm going to get the question tomorrow about how much conservatism is in there. What gives you confidence in hitting that kind of level of performance, particularly with regard to billings? Any change to your 2025 targets as you kind of look at the strength that you're seeing in the market from here on out?

Yes. The approach that we take is consistent this time around with what we've done in prior years, but certainly with added conservatism to reflect what's happening or what may happen with the macro environment. First and foremost, we start with the pipeline and looking at the pipeline growth and ensuring that we have deals teed up, especially for the middle of and possibly the second half of the year. Additionally, we want to ensure that we've got sales productivity numbers that make sense and sales capacity numbers that make sense. Yes, I think there will be some tailwind from the backlog, which I commented on. We expect to see some benefits as that continues to burn down. But keep in mind that we have seen some changes in cancellation rates, and I think we've added a significant amount of conservatism there around cancellation rates. Overall, it's about the pipeline, the tailwind that we have, and the advantages that we're offering in terms of total cost of ownership in this environment.

Okay, that's super helpful. Thank you very much.

Thank you. One moment please. Our next question comes from the line of Fatima Boolani of Citi. Your line is open.

Hey, good afternoon. Thank you for taking my questions. Keith, for you, just with respect to the services revenue guidance at 27%. That's not a material difference from the cadence you've been running at this year. I'm curious what sort of input embedded that revenue segment for you? And I ask because we have the dynamic of some of your customers delaying their subscription registrations over the course of '22. We also have the dynamic of a lot of your customers not having realized the pricing increases that you've expected in the last 12 to 18 months. So I'm curious as to why, with those positive inputs, we wouldn't see better services growth. What sort of things are you being conservative about there? And then a quick follow-up, please.

Yes. I think it kind of goes back to Brian's question a moment ago in terms of the level of conservatism and caution that's in the guidance. Historically, I have often complained that I don't get much room in the services line from where the consensus is versus what I'm forecasting. At a 27% number, I think that's pretty much right on top of what the Street expects for the full-year. I think in this macro environment, I think that's a good place for us to be at this point in the year for full-year guidance.

Understood. Any commentary on operating margin and operating profitability performance because we are seeing compression into next year, particularly on a quarterly basis. Anything to be mindful of there as it relates to maybe one-time items that are peeling out? Just perhaps why we don't see better follow-through in profitability? That’s it for me. Thank you.

Yes. Our guidance is in sync with where we are historically at this point in time and consistent with the 25% margin number we always talk about. However, what you may be suggesting is really about FX when you look at 2022 compared to 2023. We had a nice benefit from FX in 2022. Our assumptions for 2023 reflect what the dollar is expected to do, and we have pulled out a lot of that benefit.

Thank you. One moment please. Our next question comes from the line of Saket Kalia of Barclays. Your line is open.

Okay, great. Hey guys, thanks for taking my questions here. Maybe first for both Ken and Keith. Clearly, SD-WAN and OT are becoming a bigger part of the business and that too with higher growth rates. The question is, how do you folks think about the growth rate or runway for growth in those two businesses, either separately or together, over the next couple of years, as part of the total growth equation or part of the $10 billion goal, however you want to think about it? I'm really curious about that SD-WAN and OT part of the business that's been doing so well.

I totally agree that SD-WAN and the OT market are growing faster than the network security average. Our solution has huge advantages compared to other competitors. Both the SD-WAN and OT markets are still pretty fragmented compared to our integrated solution leveraged from the ASIC technology. Advantage here is much greater than that of competitors, many of whom mostly come from acquisition. Meanwhile, they don't have the ASIC aid to increase speed, lower costs, and reduce power consumption. We're set to continue growing above the market rate, as research indicates a fast-growing market compared to the cybersecurity space with considerable potential going forward.

Got it. Very helpful. Keith, a quick follow-up for you. Actually, great to see the billings duration stay roughly similar. I'm curious if you could just talk anecdotally or just specifically around how you're thinking about billings duration here in '23? Whether that's been something that you feel like customers have pushed on given the interest rate environment that we're in?

I don't think we've really seen customers push on the term. The 28 months mark has been consistent with where we've been historically. In the fourth quarter, we had conversations with customers that were perhaps even more focused on cash flow than they were on discounting. So if I were to look at what I'm hearing back from customers, it's centered around cash protection. If I were trying to do a lot of five-year deals, I might have felt more pressure. But given our SMB mix of business and partner footprint, that didn't really come through in the numbers.

Thank you. One moment please. Our next question comes from the line of Hamza Fodderwala of Morgan Stanley. Your line is open.

Hi, guys. Thank you for taking my questions. Good evening. Keith, I wanted to clarify something you said about the cancellation rates. I think you mentioned that you're seeing some changes there. Can you elaborate on that a little bit? I think like the past few quarters, it's been around 4%, 5%. Any more color on that comment?

Yes. We did see a pickup to mid-single digits in Q3, which ticked up to high-single digits in Q4. We've anticipated this, particularly as the backlog starts to shift its mix towards network equipment. While there’s still a significant amount of firewalls within the backlog, it now has shifted towards network equipment, switches, and access points which have a higher cancellation rate. We believe with the exit of the backlog, some cancellations are expected.

Got it. And just maybe a follow-up for Ken. I think SD-WAN is now nearly a $1 billion business for Fortinet, which is quite remarkable because you just started selling it, I think, maybe four years ago. I'm curious as more of that base starts to come up for refresh. What are other monetization drivers do you see for SD-WAN, whether it be attaching more services or perhaps increasing the price points? I'm curious how you're thinking about that?

Definitely more service, whether under the overlay service for SD-WAN because our SD-WAN includes all the security functions and a lot of deployment cases support work-from-corp from anywhere or helping enterprises reduce their total cost of networking. We see a lot of additional services they need. Additionally, service providers are starting to work more with us, offering some quite additional services beyond the traditional SD-WAN. This will help drive much more service going forward.

Thank you. One moment please. Our next question comes from the line of Brad Zelnick of Deutsche Bank. Your line is open.

Great, thank you very much, and congratulations on just blow-out results and guidance, a nice job. My first question is around the new ASIC FortiSP5. Can you remind us what if any impact we might expect in terms of customer purchasing patterns and what you've seen in the past? The extent perhaps it can drive accelerated demand and/or some risk of trade-down effect? I've got a follow-up.

It'll likely take one to two years to refresh the product. We tend to release one or two products each quarter, leveraging the new ASIC or the new CPU and smarter network chip in the industry. I don't foresee a significant up or down impact on the results; it will be a smoother transition. Security deployment is a kind of process that takes long time to design, evaluate, and deploy, with very long sales cycles. Additionally, the life cycle of the products tends to be quite long, like seven to ten years. So each generation of the ASIC will help in the long-term, with a significant advantage compared to using general-purpose CPUs. We're confident in our share of the market and its long-term impact.

Brad, I would only offer again for context. Fortinet has been through 20 generations of chips. The content processors and network processors and systems-on-a-chip have shown the ability to transition smoothly. Historical financials indicate it’s hard to find a year where a spike occurred simply because of a new chip release. These developments are much more long-term plays.

Thanks for the reminder. Keith, can you just expand on your comments around DSOs being up sequentially year-on-year and the impact of services revenue? Related to that, I recall you had a change in policy around subscription activations. Is that impacting services revenue as well? Any help there would be great. Thanks.

The change in activation policies started in February. The DSOs increased from 75 days to 89 or 90 days. This results in a 20% increase in DSOs, driven by linearity. When linearity shifts so much, we lose the opportunity to gain service revenue from early sales within the quarter that would normally activate. As a result, we didn’t receive a lift in service revenue from in-quarter deals as we had anticipated.

Thank you. One moment please. Our next question comes from the line of Shaul Eyal of Cowen. Your line is open.

Thank you. Good afternoon, and congrats on the great performance and guidance. Keith, given the slightly lower-than-expected 4Q service revenue, how should we think about the first quarter's service revenue growth?

We remain true to the notion of providing service revenue guidance for the full-year. The Street can work out the numbers from that point going forward. As we look at the year and the backdrop of the macro landscape, we didn't want to push too hard on some of the metrics.

Understood. As we think about the non-GAAP operating margins and impressive performance, should we be thinking of the target to be sort of an average of 25% over the period or a floor of 25% over the next few years?

Yes, you should be thinking about it in one of those two ways. We're driven by being above a 25% operating margin. However, in the past few years, we've learned that life is full of surprises. Thus, locking into a fixed commitment can be challenging sometimes. However, we clearly manage the business with 25% as a floor.

Thank you. One moment please. Our next question comes from the line of Adam Borg of Stifel. Your line is open.

Thanks so much for taking the questions. Maybe for Ken or Keith, just on sales headcount. Obviously, you guys have been aggressively growing sales and marketing headcount in recent years, and it's nice to see the enterprise success you talked about. Just curious where we are in sales force productivity. How should we think about sales headcount growth and even overall headcount growth in '23? I have a follow-up.

We're continuing to hire, but we want to ensure efficiency, as we don't want to drop efficiency in sales and marketing. Additionally, we have long-term investments such as R&D and infrastructure that we need to maintain. Thus, while we expect total head count to increase, it will be below the top line growth rate, similar to the past few years.

We do track tenure. As mentioned last quarter, the tenure of our sales team was up by eight points, now returned to historical norms. Tenure is a key component of productivity as we move ahead.

Got it. A quick follow-up just on the FortiGate and entry, mid, and high segments. It's nice to see really strong midrange growth; however, at the high end, it was the lowest mix since 2017. Just curious if there's anything to comment on there. Thanks.

That sometimes depends on certain products or backlog. The average is still quite similar. However, from quarter to quarter, it may change a bit, but the total mix remains similar.

That's one of the challenges you face in the current environment; the supply chain is fluctuating. It creates distortions based upon what's available. For instance, we saw significant availability of the 100F products, which are mid-range. Availability came in during Q4, which shifted the mix in the way you just described.

Thank you. One moment please. Our next question comes from the line of Tal Liani of Bank of America. Your line is open.

Hello. Thank you. Could you provide a backlog for 4Q or any insights about it? I'm trying to calculate bookings for the year and what happens to bookings. Any color on backlog would be great. My second question relates to product growth, which is going from 42% to 15% if my math is right from last year to this year. However, your commentary remains positive—more activity, more product sales. Can you take us through the dynamics of product growth, and the relationship between services and products? Thanks.

As I mentioned in prior quarters, the backlog has continued shifting toward the network and Wi-Fi area, which is more industry-standard products. Most of the backlog comes from networking and Wi-Fi, which tend to have higher cancellation rates. Therefore, we're taking a conservative approach on the full-year outlook. We still see benefits from the new ASIC and notable use case expansions for firewalls driving growth, but they will take time.

Today, the backlog comprises a significant amount of network and Wi-Fi products, which have a higher cancellation rate. As such, last quarter, we decided not to provide details on the backlog, as this could be misleading. The changes in cancellation rates can impact our product revenue forecasts.

While discussing directional comments, I can say that the backlog was up year-over-year but down quarter-over-quarter. However, we expect cancellation rates to increase as our focus shifts to a mix of firewalls and network equipment. Not all backlog converts into billings and revenue in 2023 due to cancellations.

Thank you. One moment please. Our next question comes from the line of Ittai Kidron of Oppenheimer. Your line is open.

Thanks. Hey guys. Nice quarter. Keith, I was wondering if you could provide some depth on the enhanced part of your business. Is there a way for you to break it down a bit for us by product? Perhaps ranking the categories that are growing above and below the average for the category? It would be useful to get some color on this change in mix.

I haven’t seen a change in the mix. The FortiManager, FortiAnalyzer, and virtual machines continue to perform very well. The tail of fabric products in areas like EDR and SIM have smaller dollar totals but very exciting growth rates. While every segment contributes, networking equipment remains a crucial component of our convergent story and represents about one-third of the fabric business.

Got it. Excellent. Just going back to the cancellation rates. How much is tied into supply chain dynamics? Is the supply chain getting better availability? Are customers less interested in waiting for product?

The supply chain environment has indeed improved for networking and Wi-Fi. Customers may have multiple orders to see which vendor can deliver first. Even for us, while we add security functions, some customers just cannot wait. As a result, higher cancellation rates have been observed.

The shift in cancellations is reflective of this dynamic. As we see changes in the mix in backlog and notice pickup in cancellation rates, it's essential to take a careful approach in our guidance setting. We are not expecting all backlog to convert into billings and revenue in 2023 because cancellations are anticipated.

Thank you. One moment please. Our next question comes from the line of Andrew Nowinski of Wells Fargo. Your line is open.

Okay. Thank you. Just two quick questions. First, I want to ask about EMEA. You've had five quarters of accelerating growth in Europe, which defies many macro trends we hear. Is there something specific in your portfolio that drives this strong growth in Europe?

We have a long-tenured and strong team there. The firewall use case has expanded well in Europe and in several countries. Additionally, some service provider carriers are more advanced compared to some larger U.S. counterparts in adopting new solutions, including 5G SD-WAN. We're also seeing impressive growth in the SMB sector as they increasingly recognize the importance of cybersecurity.

Got it. I wanted to ask about gross margins. You mentioned easing cost pressures and lower discounting as levers that drove better-than-expected gross margin. What do you think the sustainability of those factors will be into fiscal '23? When you launched the new ASIC, like you did earlier today, will that be a headwind to gross margin initially?

The price benefit will remain with us moving forward. Discounting and supply chain savings may reflect past price increases. We have nearly reached a high-water mark where price increases are covering costs, which will start to normalize. Net-net, price increases should continue, whereas benefits from discounting and supply chain improvements may not.

Thank you. One moment please. Our next question comes from the line of Raymond McDonough of Guggenheim Partners. Your line is open.

Hi, thanks. Maybe for Ken or Keith. The last time we saw product growth accelerate for two years was back in 2014 and '15, followed by a sharp deceleration in growth over the next two years. However, the business is different now. Could you compare and contrast the dynamics that relate to product growth this time versus the previous cycle?

In 2014-2015, enterprises were upgrading from traditional firewalls to next-generation systems with integrated prevention features. Currently, there’s substantial infrastructure need due to the pandemic and rising ransomware attacks. The convergence of SD-WAN, 5G, Wi-Fi, and internal segmentation has created a much broader use case for deploying firewalls across their infrastructures. We're emphasizing that this time around, we're seeing market growth with integrated solutions applied broadly across traditional networking and OT applications, which supports our product revenue growth.

Great. Thanks for the color. Could you elaborate on the behavior you're witnessing from larger customers compared to smaller ones, particularly in light of the macro environment? Are you seeing more deal delays in the upmarket or more propensity to consolidate functionality at the lower end?

Customers are emphasizing the importance of lowering their total cost of ownership, combined with a single integrated platform for better management and security. There’s a trend to merge traditional network operating teams and security teams. In larger enterprises, we see a shift towards protecting their infrastructure and pursuing our cost advantages and integrated solutions.

Yes, like others, we're reading reports about longer deal approval processes and increased scrutiny. I don’t think we’re immune to that. However, Fortinet is expanding beyond seven-figure deals into eight-figure deals. Opportunities remain, but we also need to navigate the approval processes with our sales teams and customers.

Thank you. One moment please. Our next question comes from the line of Adam Tindle of Raymond James. Your line is open.

Okay. Thanks. Good afternoon. Keith, I wanted to start with pricing. I believe we noted another pricing increase announced in January, effective in February. Could you touch on the rationale and early response to that? Also, where are we in the elasticity of demand? What would be the strategy moving forward once costs normalize?

Price increases will continue to be monitored, and we’ll make adjustments as necessary. I don't foresee significant demand elasticity changing. The recent price increase is low single digits after discounting, which is minor. In the future, if costs normalize, our strategy will depend on what happens in the market. It’s tough to lock into a fixed commitment.

Very helpful. Thank you, and congrats on the year.

Thank you.

Thank you. I'd like to turn the call back over to Peter Salkowski for any closing remarks.

Thank you, Keith. I'd like to thank everyone for joining today's call. Fortinet will be attending investor conferences hosted by Baird and Morgan Stanley during the first quarter. A fireside webcast link will be posted on the Events & Presentations section of Fortinet's Investor Relations website for the Morgan Stanley conference. If you have any follow-up questions, please feel free to contact me. Have a great rest of your day. Thank you.

Thank you. Ladies and gentlemen, this does conclude today's conference. Thank you all for participating. You may now disconnect. Have a great day.