Earnings Call Transcript - FTNT Q4 2021

Operator, Operator

Hello. Thank you for standing by, and welcome to the Fortinet Fourth Quarter 2021 Earnings Announcement 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. Please be advised that today’s conference is being recorded. I would now like to hand the conference over to your speaker today, Peter Salkowski, Vice President of Investor Relations. Please go ahead.

Peter Salkowski, Vice President of Investor Relations

Thank you, Josh. Good afternoon everyone. This is Peter Salkowski, Vice President of Investor Relations at Fortinet. I am pleased to welcome everyone to our call to discuss Fortinet’s financial results for the fourth quarter and full year of 2021. Speakers on today’s call are Ken Xie, Fortinet’s Founder, Chairman and CEO; and Keith Jensen, our Chief Financial Officer. This is a live call that will be available via replay on our Investor Relations website. Ken will begin our call today providing a high-level perspective on our business. Keith will then review our financial and operating results for the third quarter before providing guidance for the first quarter and full year of next year. We’ll then open the call for questions. During the Q&A, we ask that you please keep your questions brief and limit yourself to one question to allow others to participate. Before we begin, I’d like to remind everyone that on today’s call we will be making forward-looking statements 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 our earnings press release and in the presentation that accompanies today’s remarks, both of which are posted on the Investor Relations website. Lastly, all references to growth are on a year-over-year basis unless noted otherwise. I’ll now turn the call over to Ken.

Ken Xie, Founder, Chairman and CEO

Thanks, Peter, and thank you to everyone for joining today's call to review our outstanding fourth quarter and full year 2021 results. For the fourth quarter, bookings increased 49% to $1.420 billion. Billings increased 36% to $1.306 billion. Global G2000 billings growth accelerated to over 90%. Q-on-Q billings was up 67%, accounting for 16% of total billings. Total revenue growth was 29% to $964 million, with product revenue up 31%. Our team navigated well through a challenging supply chain environment to deliver outstanding results. For the full year, revenue was $3.3 billion and GAAP operating margin was 20%. We generated a record of $1.2 billion of free cash flow, and we recorded our 13th consecutive year of GAAP profitability. Three growth drivers, convergence of security and networking, vendor consolidation with a Security Fabric mesh platform, and an elevated threat environment are driving our strong financial results and market share gains. The move to Work from Anywhere has rapidly expanded the attack surface, which traditional network security found hard to protect. Fortinet's security-driven networking approach converges networking and security, including next-generation firewall, SD-WAN, 5G, and OT, to reduce capacity while securing and connecting remote users to advance security and performance at networking speeds. Fortinet Security Fabric platform delivers unparalleled protection through a cybersecurity mesh architecture that provides broad, integrated, and ultimate protection across multiple edges from endpoint to data center and hybrid cloud environments. Today, we announced the FortiGate 2000, the latest FortiGate next-gen firewall, powered by Fortinet's basic NP7 SPU to deliver sustainable, high-performance convergence of networking and security for zero trust edge and core networks. The FortiGate 2000 secure computing routing offers an average of 5x better performance than competitive offerings. Fortinet recently stood out amongst 19 network firewall vendors across critical capability evaluations for network firewalls. We received an overall high score in the enterprise data center, distributed enterprise edge, and SMB use cases, and the second highest score in public cloud use cases. Our FortiGate product is the only leader in both the Gartner Magic Quadrant for network firewall and SD-WAN. Over the last several years, Fortinet's industry-leading innovation has transformed our company into one of the most influential and fastest-growing cybersecurity leaders. This, in addition to our growth drivers, strongly positions us to capture market share and move to the next level of growth. 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, and we especially like to commend our operations team for their excellent job supporting Fortinet's fast growth.

Keith Jensen, Chief Financial Officer

Thank you, Ken, and good afternoon, everyone. I'll start with a summary of our very strong 2021 performance. Customer demand was strong and broad-based across geographies, customer sizes, industries, use cases, and security solutions, reflecting the three key demand drivers that Ken mentioned: convergence of security and networking, vendor consolidation on our Security Fabric mesh platform, and the elevated threat environment. Convergence or security-driven networking requires integrated security solutions to be delivered at networking speeds across the company's entire threat landscape of edges, including data centers, endpoints, work-from-anywhere, and clouds, as well as across multiple use cases such as secure SD-WAN, WiFi, switching, 5G, and OT. The networking speed and computing capabilities of our ASIC-powered FortiGates can be 5 to 10 times more than competitor firewalls using off-the-shelf silicon products. Vendor consolidation is driven by customer focus on security effectiveness, performance, and cost management. We deliver vendor consolidation through our Security Fabric platform and its broad range of products integrated with a single operating system, offering increased automation. As we saw in 2021, we expect strong customer demand fueled by these key drivers to continue. Turning to our 2021 performance, billings growth accelerated to 35% or $4.2 billion, representing our highest annual billings growth rate in six years. Revenue growth also accelerated, coming in at 29%, representing the fourth consecutive year of revenue growth of 20% or more. Despite the challenging supply chain environment, product revenue growth came in at 37%, our highest annual product revenue growth rate in 10 years. Driven by strong demand for our fabric and cloud security solutions, non-FortiGate billings and revenue each exceeded $1 billion for the first time in our history. Non-FortiGate billings increased 46% to $1.25 billion, and non-FortiGate revenue increased 42% to $1.1 billion. Gross margin was at 77.5% and operating margin was at 26.2%. Our GAAP operating margin was 19.5%, one of the highest in the industry, and we've been GAAP profitable for 13 consecutive years. Free cash flow reached a record $1.2 billion, exceeding $1 billion for the first time in our history, with free cash flow margin at 36%. Adjusted for real estate investments, it came in at 43%. Total deferred revenue increased by 33% to $3.5 billion, and short-term deferred revenue increased 28% to $1.8 billion. We are experiencing exceptionally strong demand, demand that exceeds supply by more than historical norms. As a result, we are expanding our disclosures to include bookings and backlog to provide greater visibility into the strength of our business. Bookings represent the value of all orders received from customers, while backlog represents orders received but not yet fulfilled. When an order is fulfilled, we recognize both billings and product revenue. Moving to Q4 results, as noted on Slide 4, bookings were $1.4 billion, up 49%. On a sequential basis, backlog increased $122 million due to very strong demand. On a year-over-year basis, backlog increased $150 million to end the year at $162 million. Breaking down the backlog between product and services, approximately 75% relates to future product shipments, while the remaining 25% relates to various services. While it's difficult to forecast if an order might be canceled, several factors support our view that our backlog is strong and should provide a tailwind for growth later this year and into next year. Existing customers account for approximately 90% of our backlog. No single end customer accounts for more than a low single-digit percentage of backlog. Many competitors are also impacted by supply chain constraints. Our products, along with our integrated operating system, are not commodities readily exchanged with offerings from other vendors. We actively manage our own supply chain and as the most deployed security network solution, with over one-third of all firewall unit shipments, we are an attractive volume buyer from many suppliers. Lastly, our price-for-performance advantage may be difficult for our competition to match. I apologize for the sound in the background; we don't know what's causing it, but I'll continue on. Moving to Q4 billings of $1.3 billion, billings are up 36%, which compares to 49% bookings growth noted earlier. Enterprises favor Fortinet's leading cost-performance and integrated platform, which is especially evident in the 5-point increase in the large enterprise billing mix. To add more color to this, we can share that Global 2000 billings were up over 90%, the third consecutive quarter of accelerating growth. The number of deals over $1 million increased 79% to 122 deals, breaking the 100 deal threshold for the first time in our history. We saw a record of four low eight-figure transactions in the quarter, all in the Americas.

Peter Salkowski, Vice President of Investor Relations

We're going to take a second; we can mix the phone line. We think it might be our phone for some reason. We're going to dial back in and be right back. Everybody else, stay put.

Operator, Operator

Please remain online. Your conference will resume shortly.

Ken Xie, Founder, Chairman and CEO

I will recap my recollection of where the challenge began. I mentioned that we were separating our backlog into product and services, with about 75% related to future product shipments and the remaining 25% pertaining to various services. While it is challenging to predict if an order might be canceled, several factors indicate that our backlog is strong and should support growth later this year and into next year. Existing customers make up around 90% of our backlog. No individual end customer represents more than a low single-digit percentage of that backlog. Many competitors are also facing supply chain issues. Our products, along with our integrated operating system, are not interchangeable commodities with offerings from other vendors. We actively manage our supply chain and are the most widely deployed network security solution, accounting for over one-third of all firewall unit shipments. We are a significant volume buyer for many suppliers. Finally, our price-for-performance advantage may be hard for our competitors to replicate. Moving on to Q4 billings, which reached $1.3 billion, up 36%, compared to the 49% growth in bookings noted earlier. Enterprises favored Fortinet's top cost-performance and integrated platform, as evidenced by a five-point increase in the large enterprise billings mix. To provide more context, Global 2000 billings rose over 90%, marking the third consecutive quarter of accelerating growth. The number of deals exceeding $1 million grew by 79% to 122 deals, surpassing the 100-deal threshold for the first time in our history. We recorded four low eight-figure transactions in the quarter, all in the Americas.

Peter Salkowski, Vice President of Investor Relations

Josh, can you hear us?

Operator, Operator

Yes, I can hear you. You're in the main room right now. And I can still hear these sounds.

Peter Salkowski, Vice President of Investor Relations

Okay. We're going to drop this line. We’ll be right back.

Keith Jensen, Chief Financial Officer

I'll back up a couple of paragraphs to my best recollection of where the challenge started. I believe that was around when I mentioned we were breaking down our backlog between products and services, with approximately 75% relating to future product shipments and the remaining 25% related to various services. While it's difficult to forecast if an order might be canceled, several factors support our view that our backlog is strong and should provide a tailwind for growth later this year and into next year. Existing customers account for approximately 90% of our backlog, and no single end customer represents more than a low single-digit percentage of that backlog. Many competitors are also facing supply chain constraints. Our products, along with our integrated operating system, are not commodities easily exchanged for other vendors. We actively manage our own supply chain and are the most deployed network security solution, representing over one-third of all firewall unit shipments. We are an attractive volume buyer for many suppliers, and our price-for-performance advantage can be difficult for our competition to match. Moving to Q4 billings, at $1.3 billion, billings were up 36%, compared to the 49% bookings growth noted earlier. Enterprises favor Fortinet's leading cost performance and integrated platform, which was especially evident in the five-point increase in the large enterprise billings mix. Additionally, Global 2000 billings were up over 90%, marking the third consecutive quarter of accelerating growth. The number of deals over $1 million increased 79% to 122 deals, breaking the 100-plus deal threshold for the first time in our history. We saw a record of four low eight-figure transactions in the quarter, all in the Americas.

Peter Salkowski, Vice President of Investor Relations

Thank you, Keith. As a reminder everyone, please limit yourself to one question. We lost a little time there due to the technical delays; apologies for all of that. But operator, can you open it up for Q&A, please?

Operator, Operator

Sure. Thank you, sir. I show our first question comes from the line of Brian Essex from Goldman Sachs. Please go ahead.

Brian Essex, Analyst

Hi, good afternoon. Thank you for taking the question and congratulations on a nice set of results. Thanks as well for the additional disclosure. And I guess maybe on that point, could you help us understand what qualifies as a booking and from a timing perspective if an order is placed with a timing event maybe nine months from now, is that still included in bookings? And then maybe any other incremental color you can provide us on the supply chain management? How you're managing the supply chain? You mentioned pricing increases offsetting incremental supplier costs. But maybe a view on are the issues abating at all? Are lead times still consistent with where they were last quarter? And any other nuances we should be aware of, like channel partners pre-buying inventory, which is one of the things that we picked up a little bit this quarter? Thank you.

Keith Jensen, Chief Financial Officer

Yes. There's been a lot of positive developments. Regarding bookings, when we receive orders, it's usually because customers specifically want the product. Therefore, we might not experience the scenario we initially discussed about order bookings. For us, a booking occurs when a distributor places an order, indicating they would like to have the shipment processed. That is recorded as a booking, and once we ship it, it becomes billings and product revenue. If we don’t ship, it goes into backlog. Concerning the supply chain, we previously mentioned that September, October, and possibly early November could be the low point for supply chain issues, particularly regarding decommitments from our contract manufacturers and component suppliers. So far, that seems to hold true. Occasionally, we receive commitments, but they are significantly smaller compared to that earlier period. The general sentiment with our partners, whether they are component suppliers or manufacturers, has improved greatly. Like others, we stay informed by reading reports and noticing discussions about improvements, particularly in consumer electronics and auto manufacturing. We believe the situation is continuing to get better as we move forward. Simultaneously, we are working very closely with our suppliers, having high-level discussions and exploring long-term projects, such as keeping them informed about our business volume and collaborating with our capital and engineering teams to redesign and recertify some components. All of this gives us the confidence that we should see improvements in the second half of this year.

Ken Xie, Founder, Chairman and CEO

Yes. I think you commented on all of them. Our approach is different compared to most of our competitors; we handle design and manufacturing operations ourselves. Also, we have a larger quantity compared to our competitors, which allows for better negotiation with suppliers. Our engineering teams have also started redesigning some of our products to avoid specific component shortages, which is working well for us, although some solutions may take about six months. Overall, we're confident that the second half of this year will improve, both due to the overall supply chain situation and internal planning. Last quarter, the demand was exceptionally strong, with bookings growing 49%, even beyond our planning. This caused some shortages. But overall, we believe we're in a much better position compared to competitors in inventory and supply. Additionally, we don't see increased inventory in the channel or among distributors; it’s pretty much the same as in the last few years.

Brian Essex, Analyst

Fantastic color. Thank you.

Operator, Operator

Thank you. I show our next question comes from the line of Fatima Boolani from Citi. Please go ahead.

Fatima Boolani, Analyst

Good afternoon. Thank you for taking my question. Keith, let me focus this one for you. I know you've given us the bookings growth, the billings growth, and certainly the product growth, as well as the guidance for fiscal 2022. Could you talk us through how that dovetails into your guidance for next year? And how much of this backlog you're expecting to amortize into your revenue and billings profile over the course of 2022? Additionally, I understand you've taken some substantial pricing increases for your subscription packages. I'm curious how much of that is contemplated in your guidance across these metrics? Thank you.

Keith Jensen, Chief Financial Officer

Okay. I think Brian set the standard, and Fatima is following it through. How many questions will count as one? Starting with the easy one first is pricing. We raised prices in August and again in November. On our price list, keep in mind those get discounted down. The prices for services, whether support or security, attach to the box. So when we raise prices on the appliance, we're also effectively raising prices on the services. In terms of backlog, I don't think there is one scenario that we would point to as opposed to a combination of scenarios. You can solve that possibly not on the phone right now, with some of the information provided in terms of our expectation for backlog increasing. I would not consider it reflective of bleeding into the income statement, but rather the components of the backlog will shift while net-net, it's going up.

Fatima Boolani, Analyst

Thank you.

Operator, Operator

I show our next question comes from the line of Ittai Kidron from Oppenheimer. Please go ahead.

Ittai Kidron, Analyst

Thanks, guys. Great numbers. I had a clarification and a question. Just on Keith, on the two-point shift in seasonality in the second half. Is that just tied to supply chain fulfillment? And there's no other cause here? And then, Ken, could you talk about, from a competitive standpoint, any thoughts with respect to CheckPoint's recent introduction of their Lightspeed firewall, which is extremely price aggressive? Any thoughts there would be great?

Keith Jensen, Chief Financial Officer

Yes, I'd like to clarify that the linearity may be a little bit different this year than what has been historically for us. And yes, you can point back to the supply chain.

Ken Xie, Founder, Chairman and CEO

Yes, I also mentioned CheckPoint's earnings this morning. Their newest product is probably like 20% faster than Fortinet's product launched more than two years ago. Based on Moore’s law, every 18 months the speed doubles. Therefore, their latest product is significantly faster now. However, we see network security starting to deploy across all infrastructure, not only securing the border. So when we deployed internally, there's a strong demand for high-speed firewalls needed for internal segmentation, security servers, internal department segmentations, and more. We’re seeing significant demand in this area given the current ransomware environment, as well as a need for secure SD-WAN and 5G connectivity to accommodate remote work.

Ittai Kidron, Analyst

Got it. Very good. Thanks.

Operator, Operator

Thank you. I show our next question comes from the line of Shaul Eyal from Cowen. Please go ahead.

Shaul Eyal, Analyst

Thank you. Good afternoon, guys. Congrats. I'll behave myself limiting to one question. Back to the supply chain, Keith, I just want to make sure, is that predominantly non-FortiGate products, or do we have some FortiGate products also included in that entire supply chain discussion? Thank you.

Keith Jensen, Chief Financial Officer

Yes. If you look at more traditional secure networking products such as switches and access points, you're looking at probably something in the order of 60%, maybe two-thirds of the backlog would fit into that category, and the remainder is in FortiGate. Within FortiGate, roughly one-third of the majority is in the entry level or low end of FortiGates. We're not really experiencing the same pressure in the midrange and high end that we see in the low end.

Shaul Eyal, Analyst

Thanks, guys.

Peter Salkowski, Vice President of Investor Relations

And then operator, just a quick one. I just want to let everybody know on the call, given the technical difficulties we had earlier, we'll post the prepared remarks about the CEO script and the CFO script to the IR website as soon as we can after the call. Next question, please.

Operator, Operator

Thank you. Our next question comes from the line of Ben Bollin from Cleveland Research. Please go ahead.

Ben Bollin, Analyst

Good evening, everyone. Thank you for taking the question. Ken or Keith, when you think about the elevated demand and placements on the product front, can you share any thoughts about how coincident that demand is or leading as it relates to additional fabric traction? Any thoughts or hooks around the number of applications that are being deployed typically with that initial rollout versus what comes later? Thanks.

Ken Xie, Founder, Chairman and CEO

We see a lot of enterprises needing to protect their internal networks due to the significant rise in ransomware attacks, which have increased 11 times compared to a year ago. So there's a big demand to secure the entire company's infrastructure. Additionally, as we continue to support remote working, we need more security solutions, especially like secure SD-WAN and secure 5G connectivity for these connections. Overall, the demand is very, very strong.

Keith Jensen, Chief Financial Officer

Yes, I would say one of the things that Ken asked us to review was what our product revenue growth would have been without the backlog. It would have been around 65% or 66%. That's a huge number and speaks to the robust demand for appliances right now.

Operator, Operator

Thank you. I show our next question comes from the line of Sterling Auty from JPMorgan. Please go ahead.

Sterling Auty, Analyst

Yes, thanks. Hi, guys. Keith, one for you. If I'm looking at it correct, if it weren't for the gross margin pressure, it looks like operating margins would have expanded nicely in 2022. With return to office, a pickup in business travel, and even wage inflation, how are you able to deliver that kind of underlying margin expansion in the operating line?

Keith Jensen, Chief Financial Officer

I think we’re guiding to around 25% at the midpoint for 2022, reflecting some margin compression. Sales productivity in the current environment is probably the biggest driver of leverage that we’re seeing. The price increases will indeed help increase sales productivity, contributing to operating margins despite the gross margin pressure.

Sterling Auty, Analyst

Got it. Thank you.

Peter Salkowski, Vice President of Investor Relations

Thanks, Sterling.

Operator, Operator

Thank you. I show our next question comes from the line of Adam Borg from Stifel. Please go ahead.

Adam Borg, Analyst

Hi guys, and thanks for taking the question. With SD-WAN, it’s great to see the strength continuing. Could you comment just on the sustainability of those trends in coming years? Are you seeing this growth coming more from greenfield opportunities or brownfield displacements? Thanks so much.

Ken Xie, Founder, Chairman and CEO

It's pretty broad. For SD-WAN, I’d say more than half of the majority products go to the middle or high-end range. Many enterprise customers are starting to leverage SD-WAN, making it an increasingly vital component.

Peter Salkowski, Vice President of Investor Relations

Operator, next question, please?

Operator, Operator

Thank you. I show our next question comes from the line of Jonathan Ho from William Blair. Please go ahead.

Jonathan Ho, Analyst

Hi, good afternoon. Let me echo my congratulations on a strong quarter. Given that you’ve delivered a particularly strong quarter this year, can you give us a bit of a sense of what's happening with the pipeline? What’s giving you confidence that you can continue to drive sustained growth for several more years? What are you seeing in the immediate term that allows you to continue growing at these rates? Thank you.

Keith Jensen, Chief Financial Officer

I'm thrilled with our current pipeline. We look at new customers, renewals, expansions inside customers, deal sizes, and geography. The enterprise segment saw a 90% growth on the G2000 for three quarters in a row. Pipeline growth is very strong, and we aim to enhance our marketing, aggressively hiring net sales, and sales capacity to maintain growth going forward.

Ken Xie, Founder, Chairman and CEO

There's a lot of growth potential in the Global 2000. Their accounts are growing at 90% year-over-year, offering ample opportunities for upselling and cross-selling products, further strengthening our pipeline. We continue to enhance our marketing and build our sales capacity for regions and verticals where we currently have less capacity than some of our competitors.

Operator, Operator

Thank you. I show our next question comes from the line of Michael Turits from KeyBank. Please go ahead.

Michael Turits, Analyst

Hey, guys. Thanks for the comments about the high demand for appliances. I'd like to re-ask Hamza’s question about the sources of demand for appliances, particularly around the strong cloud growth we've recently seen from others. How should we understand why there’s so much current spending on hardware versus cloud products?

Ken Xie, Founder, Chairman and CEO

The network security market is significantly larger. The cloud security market is projected to exceed $20 billion by 2025, while the total addressable market for network security, endpoint protection, and the convergence will be $170 billion. There’s immense potential in this fragmented market for significant growth.

Keith Jensen, Chief Financial Officer

And to add to that, early in the life cycle of the cybersecurity industry, we haven’t seen significant refresh cycles in the last five years due to market instability. The vast amount of data, new use cases, and the growing political interest in cybersecurity all contribute to demand. There is a hot conversation around this industry right now.

Keith Bachman, Analyst

Thank you, gentlemen.

Operator, Operator

Thank you. This concludes our Q&A session. At this time, I'd like to turn the call back over to Peter Salkowski for any closing comments. Please go ahead.

Peter Salkowski, Vice President of Investor Relations

Thank you. Again, apologies for the technical difficulties today. As I said earlier, we are planning to post the prepared remarks on our website as soon as we can so you can see all the numbers that Keith shared, which help answer some questions regarding bookings, backlog, and the sustainable growth in our business. I'd also like to remind everybody we'll be at the Morgan Stanley conference on March 9th, an in-person conference, our first in quite some time. The webcast link for that conference will be on our Investor Relations website for you all to listen. If you have any follow-up questions, please feel free to contact me. Thank you very much for your time. Again, apologies for the technical difficulties, and have a great day.

Operator, Operator

This concludes today's conference call. Thank you for participating. You may now disconnect. Good day.