Fortinet, Inc. Q3 FY2023 Earnings Call

Thank you, Anton and 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 third quarter of 2023. 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 options website. Ken will begin our call today by providing a high-level perspective on our business. Keith will review our financial and operating results for the third quarter of 2023 before providing guidance for the fourth quarter of 2023 and updating the full year. We'll then open the call for questions. Before we begin, I'd like to remind everyone that 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 take 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 cited 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 prepared remarks today for the earnings call 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'll now turn the call over to Ken.

Thank you, Peter. Good afternoon and thank you to everyone for joining our call. In Q3, we exceeded street expectations in our operating margin and free cash flow. However, both product revenue fell below our expectation due to a slowdown in secure networking growth, along with challenges in sales execution and marketing efficiency. In response to the slowdown in the secure networking market, we are shifting our marketing and sales team's focus towards a faster-growing secure operations and SASE market over the next few quarters, while maintaining our consistent focus on leading innovation in secure networking and the convergence of security and networking where we have been a leader for 23 years. While we anticipate limited near-term growth in the secure networking market, it is very important for Fortinet as we believe it enables our platform strategy with a massive footprint as the market leader in both firewall revenue and units shipped. The secure networking market is valued at $62 billion and is projected to grow at high single digits annually to $86 billion by 2027. Our consistent focus on our industry-leading DDoS, which supports over 30 network function and security applications combined with our ASIC-driven performance capability, which provides up to 10x better performance on average than competitors, continues to drive our market share gains. Secure networking remains a vital part of our strategy and a market that we believe will return to double-digit annual growth over time. We have been innovating for some time in the faster-growing segment of secure operations and SASE. Security operations, also known as SecOps, is a $46 billion market growing at mid-teens annually to $78 billion by 2027. Fortinet's platform is a comprehensive and integrated offering EDR, SIM, SAR, and other integrated solutions. Consolidation in security demands seamless integration and underlying secured tools. Fortinet's strength lies in its innovation and ability to enable automation through a high degree of product integration. Our AI and product capabilities underpin our automatic stock business, all underpinned by a single consolidated management and analytics platform. In addition to SecOps, we have continued to increase our focus on SASE, a $17 billion market expected to grow at a 20% compound annual growth rate to $36 billion by 2027. We believe Fortinet is the only company with a SASE service solution that can perform all functions in the cloud or on-premises with a common operating system, including networking and security sets, market-leading SD-WAN, vWAN, and the management console. Our SASE service solution is supported by Google Cloud. With over 100 worldwide SASE cloud locations together with our own 30-plus points of presence in data centers. For our client-based use case, we are scaling our SASE service function using our ASIC technology. For instance, we recently announced a Fortinet 1.8G with a security processor on the side, which supports our full SASE offering, which includes SD-WAN, firewall, Secure SD-WAN gateway, and threat prevention while improving secure computing performance up to 54x better than our competition. We anticipate that success in the SASE market will first come from upselling SASE services to our installed base of tens of thousands of customers. Our industry leadership in both firewall and SD-WAN, the two largest components of SASE provides us with a significant competitive advantage. We have a track record of successful execution and believe we are the only company with strong SASE service and SecOps solutions integrated into the same operational system. This differentiation sets us apart and provides us with a significant competitive advantage over peers. While we expect top-line growth to be modest for the next few quarters due to challenging networking comparisons and our business transformation realignment towards security operations and SASE, we anticipate growth to return to double digits by the second half of 2024. We remain committed to generating a healthy operating margin of 25% or greater in 2024 and 2025. 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 Ken mentioned, we are confident in our integrated platform strategy which is summarized on Slides 6 through 10 of the earnings slide deck. As we look forward, we believe shifting our R&D and go-to-market investments in the faster-growing SASE and SecOps markets is consistent with near-term market opportunities. As shown on Slide 10, SASE and SecOps account for 20% and 10%, respectively, of our business today. These markets are expected to grow in the mid- to high teens annually. Secure Networking, which currently accounts for 70% of our business, is expected to experience lower growth following two years of very robust growth. As a result, for the near term, we expect to deliver healthy profitability along with more modest growth. With execution and continued investment in the SASE and SecOps markets, we believe we can return to delivering mid- to high teens top-line growth while continuing to deliver operating margins of 25% or greater. In other words, a return to balanced growth and profitability, which has led us to achieve the rule of 40 status in 12 or 15 years, as shown on Slide 19. In a moment, I'll expand on the strategic shift by sharing a few tactical steps and investments. But first, I'd like to review some highlights from the quarter. We continue to add new logos at an impressive rate and saw top-line performance in small enterprises and software was strong while operating margin and free cash flow were above expectations. We added over 6,400 new logos, supported by small enterprise customers which grew bookings by 19%. Our efforts to manage personnel and other costs drove our operating margin to 27.8%, 230 basis points above the high end of the guidance range. Free cash flow was strong at $481 million, representing a margin of 36%. Looking at billings, starting from the third quarter of 2022, we saw a 3-year compounded annual billings growth rate or CAGR of 26%, illustrating our ability to drive strong and sustained growth over an extended period. In Q3, however, billings of $1.49 billion represented growth of 6% as we experienced a one-month shorter contract duration and importantly, lackluster appliance demand resulting from elevated product growth in earlier periods. In terms of industry verticals, education and government billings were strong, while service provider and retail billings were weak. Small enterprise billings growth was strong, while growth rates with larger enterprises disappointed. Growth varied by GEO with international emerging showing strong growth, while our much larger GEOs of Europe and the U.S. were weaker. Turning to revenue and margins. Total revenue grew 16% to $1.33 billion, which compares to our 3-year CAGR of 27%. Product revenue of $466 million, representing a 3-year CAGR of 28%, was down 1%, reflecting product lead times and backlog aligning with historical levels and lighter levels of network security demand. Service revenue of $869 million grew 28%, representing a 3-year CAGR of 27%. Service revenue accounted for 65% of total revenues driven by 34% growth in higher-margin security subscriptions which represent 57% of total service revenue. We mentioned the 3-year CAGR to illustrate how consistent they are. With the same CAGR starting from our 2009 IPO which were illustrated on Slide 18, each of the 3-year CAGRs, billings, product revenue, service revenue, and total revenue are within 5 points of the 14-year CAGR for the same top-line metrics, adding to our confidence in returning to higher growth levels. Product gross margins were down 310 basis points as we saw margin pressure related to inventory levels. Service gross margin was up 60 basis points as service revenue growth outpaced higher levels of cloud and hosting costs. Total gross margin of 76.9% was up 70 basis points driven by the increase in service gross margins and the 6-point shift from product revenue to service revenue. Operating margin of 27.8% exceeded the high end of the guidance range and operating income of $371 million was $33 million higher than consensus and $20 million above the high end of our guidance range, reflecting our efforts to control spending. Looking to the statement of cash flow, free cash flow increased 22% to $481 million, representing a free cash flow margin of 36% or 9 points above consensus. Operating cash flow increased $68 million to 41% of revenue. Capital expenditures of $70 million, including $50 million of real estate investments. Cash taxes paid in the quarter were $26 million. As a reminder, free cash flow benefited from regulatory relief in the form of deferred estimated and other tax payments in the second and third quarters, totaling $192 million and $18 million, respectively. In the fourth quarter, we expect cash taxes to total $345 million, including the $210 million of deferred tax payments. We repurchased 10.4 million shares of our common stock for an aggregate cost of $605 million in the third quarter. In October, we purchased an additional 7.7 million shares for $444 million. Our remaining share repurchase authorization stood at approximately $980 million at the end of October. Now I'd like to share a couple of key SASE wins for us in the quarter. In a 7-figure upsell win, an existing financial services customer initiated their single vendor SASE solution for 50,000 users. Fortinet was able to displace another incumbent as the customer continued their consolidation journey with us, supplementing their earlier SecOps, cloud, and network security purchases. In a 6-figure deal, an existing SD-WAN customer continued their strategic transition to SaaS and cloud-based applications by adding our SASE solution for 2,000 users. We believe existing SD-WAN customers, such as this one, offer a rich cross-sell opportunity for our SASE solution. It's worth noting these deals closed before our recently announced partnership with Google Cloud which significantly expands our point of presence coverage by adding over 100 locations and prior to Gartner's release of the inaugural single vendor SASE Magic Quadrant, where we were named a challenger. By 2025, one-third of new SASE deployments are expected to be single vendor. I should also note Fortinet is recognized in 9 Gartner Magic Quadrants as shown on Slide 3. Now I'd like to expand on Ken's strategic commentary with some of the tactical investments we're making to increasingly focus our efforts on SASE and SecOps in the areas of research and development and solution delivery, in addition to the new Google Cloud partnership and our own data center investments. We're continuing to integrate single SASE features and continuing to expand our SecOps capabilities with AI technology and additional functions in enhanced integration. We're finalizing co-development agreements with existing large enterprise customers to accelerate continuous improvement of our integrated enterprise-level SASE solution. Our go-to-market strategy involves actively promoting our challenger position in the Gartner single vendor SASE Magic Quadrant, focusing on third-party certification of our broad and integrated solutions including SSE and SD-WAN, aggressively marketing Fortinet's competitive advantages and the key components of SASE, SecOps, and network security. We also are certifying 5,500 sales professionals in SecOps solutions after already certifying these same sellers in SASE, which is the largest sales enablement motion in company history. We're investing in sales compensation plans to include incentives to sell SASE and SecOps capabilities to existing and new customers. We are expanding partner roles deeper into channel partners specializing in SASE and SecOps, and we are developing channel training focused on differentiating Fortinet's comprehensive and integrated SASE and SecOps capabilities. We believe Fortinet remains well-positioned in the cybersecurity market and the market shift to platform strategies is in the early stages. According to Gartner, 75% of companies are pursuing a vendor consolidation strategy, reflecting the evolving landscape of cybersecurity in a highly fragmented industry with thousands of vendors. Fortinet brings consolidation across SecOps, SASE, and network security, the three key growth drivers in our strategy. Organizations are recognizing that an integrated security solution with a single operating system is the best method to improve their security posture as this approach allows each security solution to share data and communicate with each other, reducing complexity and improving security effectiveness. Attempting to piece together best-of-breed solutions from multiple vendors can result in slower AI-driven technology adoption, significant security gaps, and a slower pace of identifying, reporting, and resolving security incidents. Moving to guidance, we continue to see increased deal scrutiny and longer sales cycles, which is constraining our near-term results. We expect these longer sales cycles to continue along with the associated budgetary scrutiny and our fourth quarter guidance takes us into consideration. As a reminder, our fourth quarter and full-year outlook, which are summarized on Slides 20 and 21, is subject to the disclaimers regarding forward-looking information that Peter provided at the beginning of the call. In the fourth quarter, we expect billings in the range of $1.560 billion to $1.700 billion, which at the midpoint represents a decline of 5%. Revenue in the range of $1.380 billion to $1.440 billion, which at the midpoint represents growth of 10%. Non-GAAP gross margin of 75.5% to 76.5%; non-GAAP operating margin of 27.5% to 28.5%. Non-GAAP earnings per share of $0.42 to $0.44, which assumes a share count of between 780 million to 790 million; capital expenditures of $40 million to $60 million; a non-GAAP tax rate of 17%. And cash taxes, as I mentioned, are $345 million. For the full year, we expect billings in the range of $6.095 billion to $6.235 billion, which at the midpoint represents growth of 10%. The revenue in the range of $5.270 billion to $5.330 billion, which at the midpoint represents growth of 20%. Service revenue range of $3.355 billion to $3.375 billion, which at the midpoint represents a growth of 28%. The service revenue guidance implies product revenue growth of 9%. Non-GAAP gross margin of 76% to 77% and non-GAAP operating margin of 26.5% to 27.5%, non-GAAP earnings per share of $1.54 to $1.56 which assumes a share count of between 790 million and 800 million. Capital expenditures of $220 million to $240 million; non-GAAP tax rate of 17% and cash taxes of $430 million. As we look forward to 2024 and transition from a period of elevated product growth, we offer a few thoughts looking forward. In the near term, we will continue to focus on improving profitability. We expect product gross margins to be pressured in 2024. Nonetheless, we expect healthy operating margins of 25% or greater. We expect to gradually increase billings growth through the year and approach double-digit growth by the second half of 2024, reflecting the progressively easier comparisons due to the easing of the headwinds from backlog draws in the first half of 2023 and the benefit of our SASE and SecOps focus. We expect contract terms to remain below our high-water marks of 2022. Consistent with prior years, we expect that the timing of service revenue growth trends will lag product growth trends. Longer term, we remain confident in our solutions and our ability to adapt our strategy to shifts in the market, taking market share as we increase our investments in SASE and SecOps, ultimately returning to balanced growth and profitability. I look forward to updating you on our progress in the coming quarters. And with that, I'll hand the call back over to Peter to begin the Q&A.

As a reminder, during the Q&A session, we ask you to please limit yourself to one question and one follow-up question to allow others to participate. You can now open the call for questions.

Our first question comes from Hamza Fodderwala from Morgan Stanley.

Ken, could you share your thoughts on how much SASE is impacting firewall and network security budgets? There's clearly increasing attention in that area and a focused go-to-market strategy. Do you believe SASE is starting to take market share from firewalls to some extent?

I think it's a little bit different business model. SASE is more the service OpEx compared to networking which is CapEx. During the slow economy environment, customers definitely move toward service-based OpEx. So it will be. Also, since some service providers are kind of a little bit slower to adopt some of the SASE, we have been involved in SASE for a long time. Some service providers are slower than we expected. That's where we kind of changed some of the strategy more aggressively, at the same time still working closely with the partner.

Our next question comes from Brian Essex from JPMorgan.

Keith, as we examine the decline in billings growth this quarter, it appears this might be a low point for billings. What insights do you have based on past spending cycles where you experienced negative product or low single-digit revenue growth, and subsequently saw a recovery? What factors contribute to your confidence in achieving double-digit growth for either product, billings, or both in the second half, especially considering that easier comparisons will be a factor?

Yes. Brian, great question, I should say. One of the slides that we added to the investor presentation for this earnings call actually maps out the more cyclical nature of the business than maybe we've talked about in the past with product revenue. For example, in 2017, I think we had product revenue growth of 5% and that was somewhat of a low watermark. I think there's some analyst studies out there from other members of Wall Street that have suggested that the market was due for a little bit of a pause in firewalls, and I think we're seeing that now. There was perhaps some delay of that pause because of supply chain issues and so forth, something that may have more naturally occurred in 2021 or in 2022. In terms of confidence, broadly, that was the intention of looking at the CAGRs and the success of the company since its IPO and what those CAGRs are. If you look at that combined with that new slide in the deck, you understand there has been past volatility in the industry and in the company, but over the longer stretch, you see some very attractive CAGRs in that.

Long term, we still don't believe the convergence of networking into network security will be happening, which also validates that by 2030, the network security will be larger than traditional networking, especially in the enterprise. We do believe it's a huge market opportunity. We have a unique advantage with our integrated operating system with our ASIC acceleration. We are keeping gaining market share in both network and also in the SASE market.

Our next question comes from Fatima Boolani from Citi.

Keith, in your prepared commentary, you highlighted that the service provider and retail sectors may be experiencing significant weakness in their purchasing. Ken mentioned some challenges related to the service provider buying behavior, but I would like you to elaborate on why the spending patterns in these sectors have become so notably weak. Was this part of your assumptions when assessing the pipeline? I'm looking to gain a clearer understanding of the reasons behind the decline in buying intentions in these two areas specifically.

Yes. I believe the commentary regarding service providers has likely been echoed by several other companies during this earnings cycle. The headline itself isn't surprising. However, the extent of the slowdown in the service provider sector, particularly as it affects our business globally and not just in the U.S., was unexpected. As I mentioned in my prepared remarks, we identified weaknesses in both the U.S. and European markets, which affects both the service provider and retail sectors. The retail sector might be a bit more impacted by the ongoing adjustments related to SD-WAN projects that are still in progress. Additionally, the economic headlines earlier in the quarter likely created some concern for the retail sector.

Our next question comes from Tal Liani from BofA.

Thank you. I have two questions on the same topic. If you go back to the last two years, you talked a lot about non-appliance sales, meaning upsell SD-WAN which is a head on service and then non-FortiGate. When things start to slow, we only blame the appliances. So the question is in retrospect, when you look at things and you look at the other parts of the business and you look at the add-on sales and the other features, are they all based on the ability for us to sell appliances? Meaning even if it's a non-FortiGate, it's being attached to a FortiGate sale and that's why it's going down with it or an SD-WAN, etc. So first, just to understand the total exposure of the company from all the successful products that you were able to sell over the last two years and now in retrospect, just to understand how is the exposure to appliance? The second question which is related to it is if really it's about applying sales, what is the outlook for 2024 when it comes to do you have any big refresh cycle that could drive outside of easy comps that our comps are getting easier through the year? Is there anything that you're planning on your end to drive some kind of a replacement or a refresh of the appliances?

For SD-WAN, there is a need for a platform to deliver these functions. We provide SD-WAN as a complimentary part of our service and began launching it last quarter, so it is still in the early stages of growth. We anticipate that various services will continue to gain momentum as the SASE market grows more rapidly than the secure networking market. There is a section in the presentation on Page 19 that illustrates the fluctuations in some of our products and services. This is also tied to the introduction of our new ASIC and product launches, as we recently initiated a new cycle with the ISP5, and we have one or two products being launched that will offer 5 to 10 times better performance while maintaining the same cost. The combination of this with supply chain challenges has resulted in increased shipments and production over the past couple of years. This situation will impact our sales in the short term, but we expect normalcy to return, probably in the second half of next year, after the full launch of the new products and the resolution of inventory issues. We remain confident in the long-term convergence of our strategies, especially with our well-integrated operating system as part of a comprehensive hybrid solution, which we refer to as universal SASE. As illustrated on Page 19 of the presentation, we are currently navigating through this cycle.

Yes, Tal, I'll maybe add to Ken's comments. I think you're correct in that your interest that the vast majority of the time, our first sales to customers are a firewall. It can be a virtual firewall or it could be a physical appliance. That is the beachhead that we sell to customers before we sell these other security functions and products. I think what you're seeing is in part of the shift of strategy and we talk about making the investments in SASE but also SecOps. It is really that SecOps product family like EDR and SIM that we see as doubling down on the investments. While it's not the largest of the three market segments, it is the fastest growing. We have the opportunity to participate in those markets now that some of our products have reached a greater level of maturity.

Our next question comes from Saket Kalia from Barclays.

Okay, great. Ken, I have two questions for you. First, regarding the long-term outlook, when do you believe Fortinet will have a SASE solution that can truly compete with other offerings in the market? Is that happening now, or how do you see it evolving? Additionally, what potential do you think this segment has for growth in the future? The second question is for you, Keith. It's encouraging to see strong operating margins. Could you share your thoughts on midterm profitability? Given that the business can achieve margins above 25%, how do you view the balance in light of recent changes?

Yes. The first answer is, yes, now we are ahead at competing. We believe we have a much better solution, and at the same time, much better cost ROI compared to other competitors of SASE. The universal SASE is unique because it offers both in the cloud and on-premises the same solution, which allows the customer to have a more efficient solution without needing to deal with traffic issues on their office network, as our solution can process some traffic locally on campus within their appliance.

Yes. You had a great point about whether you're talking about free cash flow or operating margin. The company does very well on the bottom line. The strategy has been to continue to reinvest that back robustly in both innovation in R&D spending but also in go-to-market efforts. I think we're looking at right now with the firewall market. Obviously, we're trying to bring new solutions to better solutions to our sellers when the firewall is a little bit slower. I think it's a workout conversation and looking at sales coverage, if you will. We've talked for several years about how many accounts we want per rep. The number is now down to 10, and that feels pretty good. I think there's another opportunity right now in terms of how we continue to support our channel partners, be they distributors or resellers and make sure that we're getting the right level of mind share from them. I would suspect there will be some investments in that part of the business as we go forward. At the same time, I think there's some opportunities here to be more efficient in how we're spending our money, whether that's in selling and marketing or back-office functions. We aren't trying to guide to 2024 today, obviously, but we thought it was important to provide at least some early thoughts in terms of maybe a floor for what 2024 should look like for us on the bottom line.

Our next question comes from Brad Zelnick from Deutsche Bank.

Great. I appreciate that as you lean into SASE and security operations, your most obvious advantage is in having an industry-leading installed base. But for those of us that have always viewed Fortinet's distinct advantage as the price performance of your purpose-built hardware. You’ve also had a go-to-market strategy, both direct and indirect that knows how to showcase that. I'm trying to get my head around all the changes in distribution, both direct and indirect, which I appreciate, Keith, you made comments about sales enablement. But how do you think about the investment in dollars and time needed to get distribution properly ramped? Can you ever achieve the same level of sales productivity that you've enjoyed when the motion was more box-centric?

We do believe that this fast-growing SASE and SecOps market requires sales training, sales restructuring, and at the same time, more efficient marketing. We're continuing to work closely with our channel partners and distribution networks to reach a broader customer base. We believe we have significant cross-sell opportunities in this more service-based SASE market. So I don't feel the investment we've made in the past will be an issue or slow us down. We believe we are helping to expand in this more service-based SASE market and also consolidating our secure approach.

And I would just build on Ken's comment, Brad; all good and fair questions. It's not by accident we're talking about SASE. We've had that conversation in various ways, and you can look at the PoP strategy that has accelerated with cloud providers to come to market more quickly. The Gartner Magic Quadrant has acted as a catalyst for our single vendor strategy; being in the challenger quadrant gives us the credibility for those conversations. We signed several hundred SASE deals without much marketing support, and it's interesting that I would have expected those first sales that would have been clearly dominated by SD-WAN. They were often times brand new customers coming to us for the SASE solution as much as there were SD-WAN customers or customers that previously purchased firewalls. Nearly 50% of the SASE customers we signed were in the SMB space, and the remainder was divided between larger and mid-enterprises. I don't think we got here by accident; we maybe just haven't been able to talk about it publicly. We're well positioned now because of the investments made in data centers, PoPs, operating systems, and our position in the Gartner Magic Quadrant with our installed base. This is the right strategic shift for us to make at this point.

And just a quick follow-up, I know it's a topic we've spoken about in the past. But as SASE increases as part of the mix, and I know strategically you've partnered with Google to help deliver the infrastructure. How should we think about the CapEx required to do this in a competitive way over the longer term?

We do have a good partnership with Google, along with other service providers. We've built several of our own data center PoPs, over 30 owned by ourselves, which gives us a cost advantage. So we're maintaining that strategy, but it does need time to ramp up. Google provides a quick solution for customers, and we feel we've separated the market into three distinct segments: Secure Networking, SASE, and SecOps, which aligns better with customer needs and demands. We're starting to track based on this segmentation and we're also compensating sales and training along these three separate segments of the market, which will be clearer for us internally and for customers and partners.

To Ken's point, last quarter we discussed 20 PoPs. Now we’re talking about over 100. This provides a go-to-market opportunity that this partnership brings to us. We're aware that some of our competitors take a different approach, one much more focused on building their own PoPs. PoPs individually aren't huge, I mean, they are single-digit number of racks at a PoP. Since we are looking at increasing more hosted delivery services, particularly in SecOps, let's not expect some surprises in our CapEx spending.

Our next question comes from Adam Tindle from Raymond James.

Keith, it sounds like you're confident in profitability and free cash flow, which makes sense. Obviously, the model has proved itself over the years. So I wanted to ask about capital allocation. The balance sheet is already very healthy. You've got a lot of capacity. Right now, the market is pivoting towards universal SASE and SecOps, as you mentioned. Curious how the conversations have gone internally to potentially accelerate your pivot towards that with larger M&A. Conversely, if we look at the after-hours action here, the ROI on share repurchase looks potentially very strong. What is the opportunity to increase share repurchases? How are you thinking about using the balance sheet strategically during a time when the business and stock is pressured?

Yes. In my prepared remarks, I mentioned that as of the start of the week, we had $980 million available for the buyback. I also shared numbers regarding our aggressive stock repurchase activity during the quarter. Canada typically does not pursue acquisitions frequently, so I will let him share his views on that.

We're keeping an eye on acquisition opportunities. I think right now, the multiples are probably more reasonable than the last one to two years. We do see that the market is changing rapidly. We will continue to invest in internal innovation. We feel we are the strongest in engineering in the space, but we are open to looking for more companies to work with and either acquire to join us.

Okay. And one quick follow-up, just to make sure Peter kicks me off the call next time for this one. But it will be in the weeds, Keith, sorry. I want to ask about supply. We've been monitoring inventory commitments. They've been elevated for a little while now. Obviously, demand is deteriorating faster than expected. We're just trying to think about how to manage inventory and future inventory given this new state of demand, where that might manifest itself in results. I think you mentioned product gross margin pressure. I wonder if that was related to that. Any comments on managing oncoming inventory relative to the current demand?

Yes, it is related to inventory levels. We've been managing it for the better part of the second half of this year. That’s some of the commentary you're getting as we look into 2024 in terms of where the pressure may come from.

We feel still in a healthy level and we tend to keep about 6 months' inventory. In 2-3 years ago when the supply chain was challenged, we were in a great position because our customers often needed urgent delivery of certain products. So we're probably still keeping the similar policy there. We are in a refresh cycle of our new products, especially end. I think we are in a much better position because we handle operations and manufacturing directly, and can manage inventory better than competitors now. We don’t see a big issue with the current inventory level.

Next question comes from Adam Borg from Stifel.

Maybe just on the sales execution issues that you talked about in the script, maybe go a little deeper on what exactly happened and a little bit more about the steps you're taking. And maybe just as a follow-up, just on the SASE partnership with Google. I know it’s only been a couple of weeks, but maybe talk about early customer feedback from initial conversations?

Yes. If you look in the last two, three years, we've been growing a lot and hired many salespeople. In the last two, three years, we've probably doubled our business. However, during the supply chain issues, certain sales felt it was too easy to get deals as there was always a shortage of certain products. That's where we felt we needed to enhance the training and enablement and be more disciplined about performance. At the same time, we’re shifting our focus to more service-based SASE and require additional cross-sell learnings. The market needs to be efficient and also project growth opportunities. That's the focus we have now.

Great. What about the early feedback on the Google partnership?

Yes, it's very positive. This gives us a very quick start to match any other competitor on location numbers. They also have broad coverage, so it's a good partnership. We're continuing to work with some other partners while also building ourselves. We believe we have more advantages than some competitors because our long-term strategy includes investments in real estate and other parts that provide much better long-term returns.

Our next question comes from Patrick Colville from Scotia Bank.

All right, Ken, Keith, Peter. My question is about being, I guess, kind of qualitative guidance you guys gave for 2024 billings. If I remember correctly, in last quarter it was expect kind of high teens growth exiting fiscal '24. Was the commentary this quarter expect double-digit growth exiting 2024?

Yes, I think that's prudent given what we've just seen in terms of the third quarter performance.

Our next question comes from Joseph Gallo from Jefferies.

I've got a two-parter, one for each of you. And Keith, as a follow-up to that last question, could you just talk about the methodology of the top-line guidance? Is this a rip-the-Band-Aid-off guide, or what underpins the confidence and visibility on a reacceleration of billings? Is it SASE turning on or just hardware digestion only taking 2 to 3 quarters? And then, Ken, given what you're seeing with AI, do you believe the adoption of AI workloads eventually shift workloads back to on-premise and drive a higher need for firewalls long term?

Yes. I would say that while we did give guidance for the fourth quarter, I think the assumed close rates are the lowest I've seen in over five years here for context. They’re obviously lower than what I saw for the first half of the year. There are indicators that pipeline quality is better in the fourth quarter but given the past two quarters, I don't think that should put much stock into that. I'm content to assume a much lower close rate. 2024 is not something we’re giving guidance for, but we’re emphasizing the impact of backlog and how it impacted numbers in 2023 as comparisons become easier. We expect to see some improvement as we bring SASE online more successfully.

Yes, it's an interesting question regarding AI and security. We're starting to integrate AI in security more effectively, both on the defense and attack sides. For general AI workloads, I feel there may be a leverage that could see workloads shifted back on-premise, driving a higher need for firewalls long term. However, we see our appliances still showing healthy growth, especially as we move towards the convergence of networking and security in enterprises. We believe the trend will continue, and our unique advantages in delivering integrated solutions with ASIC will keep pushing our growth in the market.

Our next question comes from Gray Powell from BTIG.

All right. Great. Thank you for working me in here. I really appreciate it. So maybe a clarification and a follow-up. So you laid out the breakdown for billings or the new breakdown between secure networking, SASE, and SecOps. Did you all talk about the relative growth rates that you're seeing today for each segment? And then within secured networking, is there a way to think about how much of the slowdown you're seeing there is related to the core firewall business versus some of the networking components like switches and access points and things that may have benefited more from supply chain and budget flush?

Yes. We do give the market growth for these three segments going forward. We also believe we're growing faster than the market and gaining share in all segments. With regards to the firewall versus other products like AP and switches, we do see more headwinds in AP and switch due to supply chain issues being resolved. This may be impacting the overall growth of the secure networking segment more than the firewall business.