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Earnings call: Fortinet surpasses revenue guidance, achieves record margins

EditorNatashya Angelica
Published 2024-08-07, 08:54 a/m
© Reuters.
FTNT
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Fortinet Inc. (NASDAQ:FTNT), a global leader in broad, integrated, and automated cybersecurity solutions, has exceeded its revenue guidance for the second quarter of 2024, achieving record operating margins of 35%. The company's financial results were bolstered by significant investments in the Unified SASE and Secure Ops markets, with acquisitions of Lacework and Next DLP contributing to its growth.

Fortinet's Unified SASE offering now accounts for 23% of total billings, positioning the company as a strong contender in the SASE market. Service revenue growth was robust at 20%, reaching $982 million and accounting for 68.5% of total revenue. Despite a 4% decrease in product revenue, the company reported improvements in software license revenue, gross margins, and free cash flow, which was $319 million for the quarter.

Key Takeaways

  • Fortinet's operating margin reached a record 35%, with a 20% increase in service revenue.
  • Unified SASE offering accounted for 23% of total billings.
  • Software license revenue grew by 26%, with combined revenue from software licenses and services increasing by 32%.
  • The company expects billings in the range of $1.530 billion to $1.600 billion for Q3 and revenue in the range of $1.445 billion to $1.505 billion.
  • Acquisitions of Lacework and Next DLP have strengthened Fortinet's market position.
  • Free cash flow for the quarter was strong at $319 million.

Company Outlook

  • Fortinet forecasts Q3 billings to be between $1.530 billion and $1.600 billion and revenue between $1.445 billion and $1.505 billion.
  • The company plans to invest in sales and marketing to expand its market share in the US.
  • An upcoming firewall refresh cycle is expected due to the hybrid working environment.

Bearish Highlights

  • Product revenue saw a 4% decrease to $452 million.
  • Some hesitation in the US market may be present due to the upcoming election.

Bullish Highlights

  • The international emerging markets, particularly oil-producing countries, are showing strength.
  • The company has a solid market presence outside of the US, including Europe, the Middle East, and Latin America.
  • Service providers are showing interest in offering their own SASE solutions.

Misses

  • None indicated in the provided context.

Q&A Highlights

  • The company does not plan a dramatic shift in leveraging their balance sheet in the next 90-180 days.
  • Contract duration may vary, but no significant change has been observed from the installed base.
  • Pricing dynamics remain stable with no recent price increases or pressure to decrease prices.

Fortinet's second quarter of 2024 financial results reflect a company that is not only growing but also strategically investing in key markets to secure its competitive edge. Through acquisitions and a focus on high-margin software licenses, Fortinet has managed to exceed its revenue guidance and achieve record operating margins.

The company's ability to maintain cost efficiencies and capitalize on emerging market strengths signal a positive outlook for the future, despite potential hesitations in the US market. With an eye on further investments and an upcoming firewall refresh cycle, Fortinet appears well-positioned to continue its growth trajectory. The company's upcoming Analyst Day on November 18 will provide further insights into its medium-term financial model, which will be of interest to investors and industry watchers alike.

Full transcript - Fortinet Inc (FTNT) Q2 2024:

Operator: Good day and thank you for standing by. Welcome to the Fortinet Second Quarter Earnings Call. At this time, all participants are in a listen-only mode. After the speakers’ presentation, there will be a question-and-answer session. [Operator Instructions] Please be advised that today's conference is being recorded. I would now like to hand the conference over to your first speaker today, Aaron Ovadia, from -- the Director of Investor Relations. Aaron?

Aaron Ovadia: Thank you and good afternoon, everyone. This is Aaron Ovadia, Director of Investor Relations at Fortinet. I am pleased to welcome everyone to our call to discuss Fortinet's financial results for the second quarter of 2024. Joining me on today's call are Ken Xie, Fortinet's Founder, Chairman and CEO; Keith Jensen, our CFO; and John Whittle, our COO. 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 Second quarter of 2024, before providing guidance for the third quarter of 2024 and updating the full year. We will then open the call for questions. During the Q&A session, we ask that you please limit yourself to one question and before we begin, I'd like to remind everyone that is on today's call that 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 and 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 the presentation accompanying today's remarks, both of which are posted on our Investor Relations website. The prepared remarks for today's earnings call will be posted on the quarterly earnings section of our Investor Relations with immediately following today's call. Lastly, all references to growth are on a year-over-year basis, unless noted otherwise. I will now turn the call over to Ken.

Ken Xie: Okay. Thank you Aaron and thank you to everyone for joining our call. We are pleased with our strong execution in the second quarter as we successfully balanced growth and profitability. We achieved record operation margin which increased 820 basis points to 35% and managed to building revenue in the high end of the guidance range, reached our full year 2024 revenue and operation margin guidance and we continue to invest for growth. Gaining market share and secure networking and investing in fast-growing Unified SASE and Secure Operation market. Secure networking customers are increasingly recognized our FortiOS and FortiASIC technology offering 5 to 10x better performance than our competitors while improving security effectiveness and providing a low total cost of ownership. For over 20 years, we have been leading the shift to networking and security convergence and the industry projection now indicate secure networking will surpass to traditional network by 2026, 4 years earlier than previously anticipated. In the second quarter, Unified SASE accounted for 23% of total building, up 1 point. We expect our differentiated Unified SASE offering to become a leader in the SASE market. We believe we are the only company that has built all the SASE functions organically in a single operation system. We have a converged networking and security stack, including our market-leading SD-WAN, ZTNA, Secure Web Gateway, CASB, Firewall and many other innovations. Our SASE offering provides flexible enforcement delivering a better user experience while securing access to application on-premise and in the cloud. Furthermore, we continue to build our own SASE delivery infrastructure, including leverage of FortiGate technologies, providing us with a competitive long-term cost advantage. As announced earlier today, we acquired Next DLP, a next-generation cloud-native SaaS data protection platform, extending from endpoint to cloud. This will allow us to enter the stand-alone enterprise DLP market as well as immigrate market for the SASE solution. We also recently improved our position in the Gartner (NYSE:IT) Magic Quadrant for single-vendor SASE and are the only vendor included in all 5 of major network security Magic Quadrant single-vendor SASE, network firewall, SD-WAN, secure service edge and enterprise wide and wireless in infrastructure. Each of the solutions run on our single unified operating system for the OS with AI-powered FortiGuard secure service and unified management. AI-driven Secure Ops accounted for 10% of total building in the second quarter, up 1 point. Our comprehensive Secure Ops portfolio backed by over a decade of AI experience offers the broadest range of sensors and advanced analytics to continuous access activity to identify sign of cyber strides. For AI harness generative AI to table chart our platform and help secure the operation team make better informed decision and respond to threats faster by simplifying the most complex task. Fortinet is available in FortiAnalyzer for the SIM and for store and will soon be available in other Fortinet product. In addition, we are pleased to further expand our secured portfolio with acquisition of Lacework and we believe that together, our solution form one of the most comprehensive full-stack cloud security solution available from a single vendor. Lacework organically developed AI-driven cloud native application protection platform will be combined with the power of Fortinet security platform, ensuring broad protection across network, cloud and endpoint. This acquisition increases our total addressable market by $10 billion and add a team of talented engineers dedicated to cloud-native security while also expanding our sales force that can sell the entire Fortinet portfolio of solutions. Yesterday, we announced several enhancements to Fortinet security platform which are already stand as the most comprehensive OT security platform on the market, enhancements include new recited plans [ph], advanced secure networking and secure operation capability and expanded partnership with leading OT vendors, reflecting Fortinet's commitment to security for the growing cyber physical system market. As further evidence of our innovation and commitment to excellence in OT, we recently earned a prestigious Red Dot product design work for a FortiGate Rugged 70G with Dual 5G model. Fortinet was the only secured company who will see this recognition in the industry next-generation firewall. Before turning the call over to Keith, I wish to present our employees, customers partners and suppliers worldwide for their continued support and hard work. Keith?

Keith Jensen: Thank you, Ken and thank you, Aaron and good afternoon, everyone. Let's start with the key highlights from the second quarter. Overall, we are very pleased with our execution in the quarter. We achieved record growth in operating margins at 81.5% and 35.1%, respectively, while delivering top line numbers at the high end of our guidance range. Revenue grew 11% as product revenue exceeded our expectations, driven by robust software revenue growth and sequential hardware growth that more closely aligned with historical norms. We also added 6,300 new logos as we continue to invest in our channel partners. As you'll hear in a moment, we believe we are on a pace for another rule of 40 year. At the same time, we accelerated our investments in the fast-growing Unified SASE and security operation markets with the acquisitions of Lacework and Next DLP. Lacework strengthens our position in the high-growth CGNAT market and expands our total addressable market by $10 billion, while Next DLP improves our position in the stand-alone enterprise data loss prevention market. Combined, Fortinet will gain over 900 customers and talented sales and engineering teams. And I'll just pause here to offer a very warm welcome to team members from both companies. Continuing with our Q2 highlights, we've taken the lead in partnering with the U.S. Cybersecurity and Infrastructure Security Agency, or CISA through a secure by design pledge and are leading with our responsible transparency practices. We want to emphasize, we understand customer trust is paramount to our business. Our continued success across all customer segments in each of our 3 pillars, represents hundreds of thousands of end customers testing and buying for net security solutions. Simply stated, this is a significant scale advantage and a responsibility a few others have and also offers customers validation at a very robust level. We are committed to responsible updates and deployment processes supply chain controls, product security measures and transparency. To understand more about the proactive measures we take to safeguard our customers and our reputation, please visit our trust website at fortinet.com/trust. Looking at billings in more detail. Total billings were consistent year-over-year at $1.54 billion, overcoming the headwind from the drawdown in backlog in the comparable quarter. At the same time, total bookings increased year-over-year and more importantly, the sequential growth rate approached pre-COVID, pre-supply chain norms. Unified SASE and SecOps delivered strong growth along with software while product sales recovered more than expected. We continue to see significant progress from our investments in both pillars and saw strong pipeline growth of 45% for Unified SASE and 18% for SecOps. Both pillars are gaining significant momentum within our installed base is over 90% of Unified SASE and SecOps billings are coming from existing customers. Larger enterprises continue to be our largest customer segment. with large and mid-enterprises combining to represent 86% and 82% of Unified SASE and SecOp solutions, respectively. Within Unified SASE, 40 SASE buildings continue to grow at triple-digit rates as existing customers can seamlessly integrate our solution within minutes to secure their hybrid workforce. While 40 client customers are able to use a single agent to secure Internet, private and SaaS applications. We've also integrated 40 AP with 40 SASE for securing thin edges and unmanaged devices. Our Unified SASE solution continues to gain market recognition. For the second consecutive year, we've been recognized as a challenger in the Gartner Magic Quadrant for single vendor SASE with the third highest placement in the ability to execute access. And as mentioned earlier, we are further improving our FortiSASE solution by adding powerful data loss prevention capabilities from Next DLP. Rounding out the billings commentary, the SMB was again the top performing customer segment, while international emerging was again our best-performing geography. On an industry vertical basis, technology and transportation grew at double-digit rates, while service provider and manufacturing were more challenged. Turning to revenue and margins. Total revenue grew 11% and to $1.434 billion, driven by service revenue growth and software licenses. Service revenue of $982 million grew 20%, accounting for 68.5% of total revenue. Service revenue growth was led by 36% growth in SecOps and 27% growth in Unified SASE. As noted on Slide 5, Unified SASE includes SASE and related technologies together with SD-WAN. Product revenue decreased 4% but better than expected to $452 million. Excluding the impact of backlog, product sales growth improved 14 points quarter-over-quarter and a similar amount year-over-year. Software license revenue growth continued to accelerate at 26% and represented a high teens percentage of product revenue, a nearly 5-point increase in the software mix year-over-year. Combined revenue from software licenses and software services such as cloud and SaaS security solutions, increased 32%, accelerating from 23% a year ago and providing an annual revenue run rate of over $800 million. Total gross margin increased 360 basis points to a quarterly record of 81.5% and exceeded the high end of our guidance range by 400 basis points, benefiting from higher product and services gross margin as well as a 5-point mix shift to higher-margin service revenues. Product gross margin of 66% increased 250 basis points year-over-year, mainly due to increased software mix and lower indirect costs. On a quarter-over-quarter basis, product gross margin increased from 56% to 66% as hardware demand increased and inventory levels and related inventory charges moved closer to historical norms. Service gross margin of 88.6%, increased 240 basis points as service revenue growth outpaced labor cost increases and benefited from the mix shift towards higher-margin FortiGuard Security subscription services. Operating margin increased 820 basis points to a quarterly record of 35.1% and was 840 basis points above the high end of our guidance range, reflecting the record gross margin as well as cost efficiencies within the business. Looking at the statement of cash flows summarized on Slides 16 and 17. Free cash flow was $319 million for the quarter and $927 million for the first half of 2024, or $1.1 billion after adjusting for real estate and infrastructure investments. Cash taxes in the quarter were $252 million. As a reminder, last year's second quarter benefited from the deferral of approximately $190 million in cash tax payments which were ultimately paid in the fourth quarter of 2023. Infrastructure investments totaled $23 million. Average contract term in the second quarter was 28 months, flat year-over-year and up 1 month quarter-over-quarter. DSO decreased 7 days year-over-year and increased 2 days quarter-over-quarter to 68 days. While we did not repurchase shares in Q2, share buybacks have totaled $5.3 billion over the last 4 plus years and the remaining buyback authorization is $1 billion. Now, I'd like to share a few significant wins from the second quarter. In a 7-figure deal, an international government agency purchased 12 solutions across all 3 pillars, including 8 SecOp solutions. This new customer selected Fortinet because of our operating system's ability to consolidate over 30 networking and security functions into a single unified platform, covering SecOps, SASE and Secure Networking. The customer was impressed with the integrated security, end-to-end visibility and automated response features of our FortiOS operating system. Next, in a 7-figure win, a large utility company, expanded our partnership by signing their first enterprise agreement with us to safeguard their OT environment. This deal displaces 5 legacy vendors and includes ruggedized equipment deployed to the customers' power plants, control centers and substations. Keys to this expansion win were our proven expertise in securing critical infrastructure and our price for performance advantage. And lastly, in a competitive displacement win, our retail store chain purchased our FortiSASE solution in a 7-figure deal. This customer chose Fortinet because of our integrated FortiOS platform, as they were able to seamlessly integrate FortiSASE with their existing Fortinet security solutions. Now I'd like to offer some comments on customer inventory digestion and the firewall refresh cycle. Last quarter, we pointed to a 25% improvement in the number of days of registered FortiGuard contracts from its peak and view this as an early but soft indicator of that "inventory digestion" at end users appear to be normalizing and the firewall market could start to show signs of recovery. To provide an update on this indicator and other signs of possible improvement in the firewall market, we can share that as shown on Slide 19, in the second quarter. The days of registered security service contracts improved another 12 days and has now returned to 2020 pre-supply chain, pre-COVID crisis levels. Inventory commitments and levels are normalizing at our contract manufacturers and in the channel. And as noted earlier, the sequential increase in hardware sales in the second quarter aligned more closely with historical norms. While these indicators are positive, we believe customers are currently managing a tough macro environment and a key election year in the U.S. and we believe this is having an impact on our customers' purchasing decisions. As a result, we believe a full refresh cycle is unlikely to occur in 2024 but more likely in 2025. Moving on to guidance. As a reminder, our third quarter and full year outlook which are summarized on Slides 21 and 22, it's subject to the disclaimers regarding forward-looking information that Aaron provided at the beginning of the call. Before reviewing the outlook, I'd like to offer a few modeling notes in light of our Lacework and Next DLP acquisitions, covering estimates included in our Q3 and full year guidance. For billings, the acquisitions increased Q3 by approximately 0.5 point and the full year by approximately 1/3 point. Total revenue increased Q3 and full year growth by 1 point and 1.5 points, respectively. For gross margin, they decreased Q3 and full year margins by less than 0.5 point for each period. For operating margin, they decreased Q3 and full year margins by 3 points and 1.5 points, respectively. Inclusive of these acquisition-related estimates, for the third quarter, we expect billings in the range of $1.530 billion to $1.600 billion which at the midpoint represents growth of 5%, revenue in the range of $1.445 billion to $1.505 billion which at the midpoint represents growth of 10.5%. Non-GAAP gross margin of 79% to 80%. Non-GAAP operating margin of 30.5% to 31.5%. Non-GAAP earnings per share of $0.56 to $0.58 which assumes a share count of between $767 million and $777 million. Capital expenditures of $40 million to $60 million. A non-GAAP tax rate of 17%. And cash taxes of $125 million to $145 million. And again, for the full year, inclusive of the numbers we gave a moment ago, we expect billings in the range of $6.400 billion to $6.600 billion; revenue in the range of $5.800 billion to $5.900 billion which at the midpoint represents growth of 10%. Service revenue remained of $3.975 billion to $4.025 billion which at the midpoint represents growth of 18%. Non-GAAP gross margin of 79% to 80%, Non-GAAP operating margin of 30% to 31.5%. Non-GAAP earnings per share of $2.13 to $2.19 which assumes a share count of between 767 million and 777 million. Capital expenditures of $320 million to $360 million. Non-GAAP tax rate of 17% and cash taxes of between $525 million and $575 million. I look forward to updating you on our progress in coming quarters. Before we begin the Q&A session, it is with deep sadness that we recognize the passing of our friend, Peter Salkowski, our SVP of Finance and Investor Relations. Peter was an integral part of the Fortinet team for over 6 years and was renowned for is passion for mentoring and developing the next generation of leaders. We'll miss Peter and fondly remember his commitment to fostering talent and nurturing potential within our company. I know that Peter worked closely with many of you on this call and the outlining of condolences and heartfelt memories you've shared since his passing clearly shows the positive impact he had on so many people's lives. Peter took great pride in his contribution to Fortinet and rightly so. having contributed to increasing shareholder value from $8 billion to $46 billion during his tenure Fortinet. We'll miss Peter. Aaron, back to you.

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

Operator: [Operator Instructions] Our first question comes from the line of Brian Essex of JPMorgan (NYSE:JPM).

Brian Essex: Sorry for your loss. Keith, if I could maybe touch on the margins. I think it's incredible margin results for the quarter. Could you help me understand or maybe unpack outside of the obviously, the gross margin benefit that you saw in the quarter. Maybe help me understand where you saw better cost efficiencies, how sustainable are they particularly in light of the effort to incentivize the channel and the sales force to focus more on selling SecOps and SASE with maybe some incremental effort?

Keith Jensen: Yes. I think the gross margin is the largest driver of what you saw in the operating margin, particularly when you look at it on a quarter-over-quarter basis and in that, we talked about or made reference to a more normalized environment for us in terms of inventory levels, turns and what we're seeing with channel inventory but also commitments to our contract manufacturers. So I think that we've been working through that for probably the last 3 quarters, maybe 4 quarters. And with that, I would say, I think we've returned to a more normal state and so I would expect that to continue on. I think we're getting a little more contribution from sales and marketing than maybe I'd like at the moment and I would expect us to make a little bit more investments there as we go through the second half of the year. Keep in mind, we're getting a very large group of salespeople as Ken made reference to from both the Lacework and the Next DLP acquisitions. But I think we feel certainly comfortable with the guidance that we've given for both Q3 and for the full year on the margin line.

Brian Essex: Great. Maybe just a quick follow-up. How should we anticipate the impact of the operating margin to reflect on free cash flow as we look through the rest of the year? Should we look at historical spread between margin and cash flow margin and maybe estimate kind of ballpark the same kind of spread? Or are there going to be more puts and takes like timing of tax payments that are going to mess with that free cash flow margin as we fine-tune our models?

Keith Jensen: Yes. I don't -- I mean, I think it's a good starting point is to look at the improvement in operating margin flowing through to free cash flow. Some of the changes that we monitor would be things like contract duration but you've seen now that industries and companies have been talking about contract duration for several quarters and you really haven't seen that come through to us yet. I should say, yes, habits going to come through to us. And so I'm not I think we have opportunity to leverage our balance sheet more with our customers and prospects that we have. But I don't see over the next 90 days or 180 days, a dramatic shift in that area.

Operator: One moment for our next question. Our next question comes from the line of Hamza Fodderwala of Morgan Stanley (NYSE:MS).

Hamza Fodderwala: I'll echo my condolences for Peter and his family, we'll definitely miss them. Keith, I wanted to follow up on the margin question because obviously, it was a very strong beat, I think a lot more than any of us were expecting historically, Fortinet has kind of managed the business towards the 25%-plus type operating margin run rate. I'm curious, is this the new base that we should sort of think Fortinet goes off of longer term? Or is it sort of a onetime margin outperformance given what you saw on the gross margin side coming out of the inventory digestion headwinds?

Keith Jensen: Yes. Again, I think the inventory part of that is I think we've worked our way back to a more normalized state. So I think that is our business model going forward for it that way. There can always be something that changes but I don't see us anticipating something in the gross margin line and that is by far and away the biggest opportunity there. I think it also says that we clearly have the opportunity to more -- invest more in go-to-market than we did in the first half of this year. And I think we've factored in some of that investment ideas or those ideas in our forecast and our guidance. In terms of whether or not I make Ken Cry, when I increase the margin the way I did, that's a different topic and I'll let him respond to that.

Ken Xie: Also, we'll benefit from the service revenue which has a much higher margin compared to the product revenue. So once the product starts growing, because product has a lower gross margin, that probably will impact the margin but the product is also the leading indicator of future service. So that's where we kind of also were happy to see the product also starting growing now which I think going forward with the product has a higher percentage, that probably also will impact the margin.

Operator: Our next question comes from the line of Fatima Boolani of Citi.

Fatima Boolani: I wanted to share my condolences for Peter, he was just a fantastic person and he will absolutely be missed. Keith, I wanted to zero-in on your comments regarding software license growth. You talked about that accelerating 26% year-on-year, I believe and now it constitutes a high-teens percentage of your product revenue, I wanted to understand what are the drivers behind that massive mix shift and how we should think about the trajectory of this mix shift in the context of your guidance for the remainder of the year and bringing into consideration some of the hardware digestion, potential prolonging comments that you shared as well, if you can help us square that away?

Keith Jensen: Yes. I think the software license, if you kind of step back and look at what the business model is not to make it only simplistic, we want to -- it's so compelling to start with the firewall and it's very compelling to start with the ASIC. So a physical part of it, we don't always do that but we almost always start with a firewall, whether it's physical or virtual. Really, what you want to do is get the operating system in the hands of the customer. And what form factor that takes is we're fairly agnostic about that. So once that happens, then you start to see the knock-on effect of either selling more firewall use cases and other form factors into organizations or you're seeing that full portfolio, the SecOps product line take hold as continuous to expand throughout organization. So I would expect that we're going to continue to see tailwinds and growth, no doubt about it from the software part of the business. Will there be a mix shift that slows a little bit when firewall and FortiGate starts to return? Sure, absolutely. But this has been a trend that we talked about a little bit, I think, last quarter and probably some earlier quarters about the software mix and the mix shift that we've been seeing. So I would expect that, that's going to continue on given the success we're seeing in the other 2 pillars.

Ken Xie: In the FortiSASE and FortiOS, we see customers setting turn around more and more function which also enable more service for us. At the same time, the FortiSASE Secure Ops has also fully pretty much our service base and plus a lot of secure a high percentage in software compared to the hardware on the secure networking part. So that's both helping drive the additional software and licensing growth.

Operator: Our next question comes from the line of Gabriela Borges of Goldman Sachs (NYSE:GS).

Gabriela Borges: Either for Ken or for Keith. On the firewall refresh cycle, I can appreciate your comments on not expecting to see a recovery in 2024. Share us a little bit more detail on why you think we'll see it in 2025. And -- to what extent are customers giving you an indication that they will be refreshing in 2025, perhaps as we get through the election and some of the macro or perhaps because of their updated depreciation plans? Any color on why you think the timing will be 2025 would be helpful.

Ken Xie: I think it's probably more Keith. I think the rest of the year probably still pretty tough to make an environment where the election or some interest rate is still pretty high. The money cost is pretty high that's where some companies may not really want to spend some long-term investment which is drive the product revenue and building infrastructure, so that's what we view. Also, if you look at it historically, every 4 years -- 4 to 5 years, the network here or another network in our security they need to be refreshed for faster, more function layer. So that's where we feel when we're starting this supply chain issue, they artificially put up the since lag started in 2001 [ph], maybe next year will be pretty much full year cycle now. So some company may start looking to refresh the product they purchased 4, 5 years ago, especially in certain vertical like retail, some other we see pretty strong growth in early days of a supply chain issue and we feel probably in the next 1 to 2 years, they may starting to return to see some investment on the infrastructure. On the other side, we see the big trend we always believe, always a hybrid mode, even there's -- like we have a very advanced SASE infrastructure side but also to secure OT/IoT area, to secure a lot of infrastructure, work for home and we do need an appliance in the field. And also even for SASE, we do offer both cloud-based SASE and also on premise-based private SASE. So that also needs some hardware to support in local for the customer.

Operator: Our next question comes from the line of Tal Liani of Bank of America (NYSE:BAC).

Tal Liani: The fact that -- can you go back to the fact that billings, you made 2 acquisitions this quarter, you didn't change the billing guidance for the year but you did beat the numbers for this quarter by $20 million, so in effect, you reduced the billing for the next 2 quarters. What are the drivers in billings? I know we spoke about it in the past but what are the drivers for billings and what's the outlook for billings going forward? Second question is your -- you grew revenues by 11%. But when you look at OpEx, they're flat. And you don't do buybacks now what's the outlook for buybacks? And what's the outlook for OpEx? Will it start growing now that you started executing on revenue growth.

Keith Jensen: Tal, I think I kind of missed -- very, very faint on your questions there. Maybe if you can give us maybe a little later recap of the 2 questions you had.

Ken Xie: I think that get some part about the 2 acquisitions impact on billing. I believe the post-acquisition, I think, Lacework maybe this year will contribute or maybe...

Keith Jensen: Yes. I think that -- I mean if you kind of look at the recap of the year, there's not a lot of variability in it, if you will. We are a little bit light in the first quarter, we came back and recovered the first quarter shortage in the second quarter. Now you see us looking at the third quarter and maybe taking that just a little bit off of some of the Street numbers and looking to see a little bit of that back in the fourth quarter. But we're kind of taking the third quarter correction to the Street numbers and putting it into the full year number. But yes, offsetting a very, very similar amount in terms of what we expect to get from the acquisitions and that leaves the full year range very much intact. And I understand that tick up is quick, I understand part of that is I'm taking -- I'm getting inorganic benefit in that number of the 0.5 point that we talked about at the -- and really taking down the organic part of the business. But again, I think we're talking about small numbers here.

Tal Liani: Got it. My second question can hear me okay now. But my second question was about OpEx that was flat and no buybacks. What's the outlook on those items?

Keith Jensen: Yes. I think the OpEx is probably a little lighter on the sales and marketing line than maybe we would like to see, particularly as we start looking at more opportunities as we get into the second half of the year and into 2025. So hopefully, we'll find some opportunities there to make investments. Obviously, you're going to get a fairly significant movement there from the 2 acquisitions that we just did and we gave the number about what the OpEx impact is going to be, that will largely be in sales and marketing. Buyback, I think that we still remain being opportunistic and that opportunistic number changes every 90 days as we reset our plans.

Ken Xie: Yes. And also, in the market, whether the private company, public company, we see the multiple probably more friendly for [indiscernible] compared to the last 2, 3 years. So we should go back to more reasonable so that we see some opportunity there.

Operator: Our next question comes from the line of Rob Owens of Piper Sandler.

Rob Owens: Curious relative to the macro and obviously a lot of cross currents out there, maybe what you're seeing via your different customer sizes and different theaters?

Keith Jensen: Yes. I think because we are so diversified, as you kind of alluded to, 70% of the business is international and a little bit less than 30% in the U.S. And yes, there's been a lot of elections around the world this year but it's certainly the U.S. election, maybe weighing on people and every kind of taking a position of waiting to see. As you move -- pull back from that, the international emerging part of the business has been strong, very strong for several quarters and continues on to be. A lot of those are oil-producing countries and similar. So I think they've done well in this economic cycle. There are a little more risk there perhaps with geopolitical events in some of those countries. But to this point, it really hasn't had an impact there. We are much more likely to be the number 1 market share when you move outside the U.S. and parts of Europe and the Middle East and Latin America and parts of APAC. And I think having an incumbency advantage, if you will, helps you in those more challenging times because you're there, you're on site and you have that opportunity to cross-sell and upsell your installed base.

Ken Xie: In the U.S., last next growing area which also needs more direct marketing, direct sales. That's also need more investment. So that's where we do plan to invest more into sales and marketing to keep gaining market share in the U.S.

Rob Owens: And Keith, if you contemplate these acquisitions and a little bit of mix shift to software and I realize hardware is weak right now with the potential recovery next year. But how are you thinking about billings duration? You shave some off the back half and I think some of that's probably the mix shift towards software as we kind of look overall at the model and the increase in revenue but as we contemplate 2025, how should we think about billings duration and potential compression with more cloud-based or software deals that are likely shorter in nature?

Keith Jensen: Well, I look forward to seeing you in November at the Analyst Day and we'll talk more about 2025 and midterm numbers. But in the interim, I would probably say that if it's a white space account in some of these places like Lacework would be, for example, I think it's going to be much more prone to having a shorter duration contract. If it's part of that 90% of be selling SecOps or SASE solutions to my installed base. What I'm seeing to this point is my installed base continues to purchase in terms of contract duration, the way they have historically. So they haven't -- if I sell something from the SecOp portfolio into one of my firewall customers, they tend to sign up for a longer duration contract than you may see from a point solution vendor.

Operator: Our next question comes from the line of Shaul Eyal of TD (TSX:TD) Cowen.

Shaul Eyal: Keith or Ken, so listening to Keith's commentary about the potential refresh cycle not taking place in the second half of this year but most likely during 2025. And again, not trying to front run the November Analyst Day but should we be thinking about 2025 accelerating over 2024? And again, I know you don't have the current visibility to guide to '25 but just conceptually, is it fair to assume another year of double-digit growth?

Ken Xie: We do believe next year, there's -- I think first, overall, we see the long-term convergence -- networking convergence to network security, we're still keeping going. That's why we do give the CAGR in secure networking area is about 15% year-over-year growth. If you look in the investor presentation slide for about which page. But on the other side, we also see a lot of new opportunity, whether in the OT area in the Unified SASE and also upsell, cross-sell which are all helping driving, I would say, probably like a 90% customer initially moved by a FortiGate getting the firewall and network security market first which we have a huge advantage over competitors. But after that one, they're keeping expanding beyond the network security, go to the other area. So that's what's happening for the Unified SASE for the Secure Op. And now the product, especially on the FortiGate firewall side we're starting to see kind of go back to normal or starting growing with the market now. So, we do feel probably next year will be whether the refresh cycle which after -- that's where the existing customer, if they have the product for 4, 5 years, that's probably the average turn starting to refresh. And so we do see probably next year, we're starting that process.

Operator: Our next question comes from the line of Brad Zelnick of Deutsche Bank (ETR:DBKGn).

Brad Zelnick: Keith, I think you called out the service provider segment is more challenged this quarter after being a strong performer last quarter. And I know it's lumpy and remains a top vertical as it always has been for Fortinet. But can you share an update on what's happening in that segment? And in particular, how your value prop and unified -- and focus on Unified SASE and SecOps applies in this important vertical?

Ken Xie: Yes. I don't feel the service provider telecom slowdown, it's really kind of lumpy and on the other side, we're also starting to see the telecom service provider more interest in offer their own SASE using our product solution or kind of helping customers do the private SASE, localized SASE which also will helping drive our long-term growth. But I do believe long-term wise, the service provider will be if not the biggest, probably one of the biggest part of the whole cybersecurity business because they have the infrastructure, they have the customer relation, so we still want to keep a focus on the service provider area. But for them, it's really the sales cycle resting is long and the deal pretty big, like 8-figure deal. That's where the lumpiness probably impacted the quarterly. But if you look at more long-term multi-quarter annually, I don't believe it's still keeping growing.

Keith Jensen: Yes, Ken is spot on, right? It's a lumpy industry. Financial services can be to at times as well. But I think more importantly, I think the conversations around their own independent SASE solution that they can bring to market is something that's getting a lot more conversation from the service providers. I think we saw it first internationally and we're starting to see a little bit more of it here domestically. But that's going to -- that's a pretty exciting opportunity if it continues to move forward.

Brad Zelnick: Just a quick follow-up on the very impressive operating leverage that you've shown us particularly on the sales and marketing line, where I know, Keith, you said that it's more than you'd like to see at this point. But just structurally, like to see it down, albeit very slightly sequentially on a dollar basis, especially as you outperformed on the top line and billings this quarter. I'm just trying to understand like where it comes from? And is there anything structurally that change that we should be thinking about, whether it's commission deferral rates, channel rebates or anything else other than headcount?

Keith Jensen: Yes. I think there's a few things going on there. I think probably 9 months ago, we looked at the cost structure pretty closely. And across a number of areas. And the first place that people kind of look at and when you're in that vote is marketing programs and they get hit pretty hard early on. And I think you're trying to see that roll through you do make changes to your compensation programs, whether it's for direct salespeople or for channel people or what have you. And I think maybe as we're coming out of that environment now, it's important for us to kind of revisit some of those decisions and making sure I kind of talk about the investment opportunities that we have in the sales and marketing line. And I think I would include the channel net as well. It is why I would say that to your point or you're repeating me, probably a little bit lower than we would have liked it to have been in the second quarter. And I think we'll continue to make go-to-market investments here in the second half of the year.

Ken Xie: Yes, I agree with Keith. We're starting tracking more carefully for the ROI for each investment in marketing sales and also try to improve the efficiency with the marketing sales. On the other side, we are a little bit behind on hiring in the sales and marketing side which we intend to accelerate. So that's actually what will drive the future growth.

Operator: Our next question comes from the line of Adam Tindle of Raymond James.

Adam Tindle: I just wanted to continue the margin discussion. Obviously, you had great product gross margin performance this quarter on top of those tight cost controls. And the question really is around pricing dynamics in the core firewall business from here. The supply chain sounds like it's clearly normalized. You've had multiple years of price increases during this period of time. What are your expectations of the pricing dynamic in core firewall from here? What would it take to maybe even consider reducing price back to historical at some point? And any comments that you want to make on the competitive environment in light of this?

Ken Xie: I think we have not increased the price in the last few quarters. I think that because we still believe we have a huge advantage with FortiASIC, FortiOS technology has a more function better performance, lower total cost of ownership and also energy cost. So we feel we're keeping that advantage over our competitors. On the other side, we don't see any pressure to also decrease price all kind of discount more. So that's where we feel we're keeping pretty stable for the price. And at the same time, that the customers see the benefit of our product solution and with better performance, more function which also will drive the future service. I think the bigger environment also, we don't feel changed much. Definitely, we see that the inventory all go back to normal weather on kind of inventory and also the channel inventory. That's also more helping driving the healthy behavior in the business also in the supply chain area. Maybe Keith has something to add.

Keith Jensen: Just to repeat what Ken said, maybe a little more granularity. I think the price increases that you referred to, we're really probably a late '21, 2022 impact. And I don't think we're really raising prices at '23. We did take some prices down at the end of '23 and in the very beginning of 2024. But that's really been the only pricing actions we've taken in the last 6 months. And then to Ken's point, I think we're at a moment where we think it's probably -- the value for the solution is very, very strong. I think the energy costs that Ken mentioned is starting to get -- it's gotten a lot of traction internationally in Europe but you're starting to see more conversation around that in the U.S. and that could be people concerned about energy consumption and issues with AI and EV and government actions on manufacturing. So I do think the energy cost advantage is coming into play more. And then last one on that discounting was, I think, very much in line. I think we actually improved discounting meaning higher prices by about 1 point quarter-over-quarter and kind of a similar number one way or the other for the full year. So we obviously have room given the margins to use discounting and pricing as a lever. But I think there's other things that we'd like to push on first.

Operator: Our next question comes from the line of Adam Borg of Stifel.

Adam Borg: Also condolences on Peter's passing. He's certainly missed by all of us. We'd love to talk about the Next DLP acquisition. Maybe talk a little bit more about what's attracting you to the stand-alone enterprise data protection market overall and Next DLP in particular?

John Whittle: This is John Whittle. There's a lot of positivity around that. We obviously just announced it today, we closed it yesterday. We did a lot of diligence on the company, The tech is great. And not only will we plan to offer it stand-alone but also integrated with our FortiSASE solution. And so I think it's another step in steadily bolstering our FortiSASE solution, We feel very, very confident in our strategy there. For the most part, as you know, I mean, we've done some tech and talent tuck-ins. Most of our technology is organic I think to some of the earlier questions, you think about the firewall market coming back next year. And we really just started kind of organizing our solutions into these 3 pillars less than a year ago and the amount of progress we've made and the execution we've made in kind of developing very, very competitive solutions in SASE and SecOps in addition to secure networking is pretty impressive. And I think this is an important step along the way to continue to develop the best SASE solution out there to protect our customers.

Adam Borg: That's great. And maybe just as a quick follow-up there, John. Maybe just could you comment on current level of sales force productivity for SASE and SecOps and the opportunities for improvement from here?

John Whittle: Sorry, the sales execution with SASE and SecOps.

Adam Borg: Just general sales force productivity as you've gone through many months at this point of training and just ramping of the ability to sell that across your company globally.

John Whittle: Yes. No, it's a really good question. I think what we're seeing is it does take time. We are very focused on that broad sales enablement I always say, I mean, the opportunity just abounds from our solution set and we're always with a customer-first focus. So in terms of protecting and serving our customers the opportunity to bounce I think our sales force -- the good news is they have a ton of opportunity. I always say they're going to suffer more from indigestion than starvation. But we've got really a big focus in the company to really train up that sales force, enable that sales force, make sure we have the incentives in the right place and make sure we have the support. So when they do qualify different opportunities in different solution sets, the support to support them in that sale. So I think, like Keith had alluded to, we often land with the firewall and then expand and get that support to our sales force with SASE and SecOps solutions and we're seeing a lot of success there.

Operator: Our next question comes from the line of Saket Kalia of Barclays (LON:BARC).

Saket Kalia: Tip my cap to Peter as well. We're going to miss him. Ken, maybe just to start with you. I wanted to get into just the firewall refresh for next year a little bit. I mean you've seen so many refresh cycles over the years. How would you sort of compare this upcoming cycle versus others in the past? And maybe touch on how SASE and sort of -- maybe what sounds like a higher mix of virtual might sort of play into that?

Ken Xie: Yes, agree. There's the infrastructure probably different than the last refresh cycle. You see more hybrid working environment, whether working remotely and also more supporting broad connection, including connect all this OT/IoT device level. For the SASE, we always believe also should be a hybrid SASE environment, not just cloud only. You do need to have a private SASE, some other local SASE offer by service provider. And also some time, the SASE also need secure some device which cannot install a software agent like using a FortiAP, FortiSwitch to secure this agent is device. So that's where we feel this also will always kind of the unified SASE will be the long-term future. We believe we also combine both the hardware and the software and infrastructure and appliance together. So that's where the refresh. On the other side, network security is always probably the biggest market -- I mean it has been the biggest market in cybersecurity for probably 30 years now, 20, 30 years and keep expanding because more people devices get connect and more application to access or even as cloud, you do need to secure on the network side. So that's what we see when you try to access the network side and also the long-term convergence of network in network security, that's also what drives the refresh. That's also you can see the Gartner research we pointed out, the convergence of network in the network security also starting or accelerating. So originally, I think last year, they say by 2030, the secure networking will be larger than traditional networking. Now they say, 2026, 4 years ahead, the secure networking will be larger than the traditional networking. So that's where we really invest long term on this trend. And with all this FortiOS, FortiASIC and making the best both appliance and infrastructure, the ASIC technology and at the same time, also try to investment more in the sales and marketing area to really catch the trend and also keep gaining market share. So that's the strategy to be ahead.

Saket Kalia: That makes a lot of sense. Keith, if I could fit in one quick follow-up. Just on the software mix in product, I think you said, call it, roughly $800 million run rate. Can we just touch on, even anecdotally, roughly how much of that is sort of virtual firewall versus SecOps? And I realize they're coming in at software gross margins. But can you put a finer point on that and sort of what that aggregate business might be coming in at from a gross margin perspective as we think about that gross margin shift long term?

Keith Jensen: Well, I think whether it's a virtual firewall or any other software product or the software licenses are all coming in at very, very attractive margins. I think that when you look at some of the SaaS solutions that are sitting in the services line for SecOps and so forth, you get a very wide range of margins there but it's only because of the relative size or maturity of the solution. Obviously, something that's very new and absorbing a lot of the hosting cost is a little harder. But those aren't as big numbers. As you see those SecOps solutions get greater and greater traction and more critical mass, the margins start to normalize. I think kind of what's really been exciting is the ability to absorb those data center POP, colo, everybody's got their hand in the products and on these things, cloud provider fees and developing the SaaS solutions and still bring up the services gross margin. And by the same token, being able to absorb the charge for Lacework on the operating margin line because we've managed the business in terms of cost of goods sold for the product side, I think we're really, really pleased with how those 2 things will work hand in hand.

Operator: Our next question comes from the line of Joseph Gallo from Jefferies.

Joseph Gallo: I also want to echo my condolence to the team and Peter. Sadly, big shoes to fill. I just wanted to double click on what drove the better performance in product in 2Q? Was there some large deals or region, segment or vertical that stood out, especially since you don't expect the refresh benefit until calendar '25?

Keith Jensen: No, great question. I mean we've talked about 8-figure deals and our size 8-figure deals can kind of still will around, as you saw in the fourth quarter last year, we did 6 of them. We had one 8-figure deal, Q1. We had 2 in Q2. So I would wouldn't attribute to that. I think what we saw the last month of the quarter and particularly as we got into the last week of the quarter, what you see in a strong market is a lot of deals started to fall in place and we're getting across the finish line. I think we saw a lot more positiveness if you will, at the end of Q2 than maybe we saw say at the end of Q3 or something like that last year.

Joseph Gallo: Okay. And then just on a follow-up to that. And I think it was a follow-up to Fatima's question. Given that mix shift, you now expect in the second half, given the delayed refresh, what is your confidence or visibility into the billings re-acceleration in the second half? Do you, in theory, have more visibility now, given that it's less hardware based? Or how are you thinking about that?

Keith Jensen: Yes. I don't think that the form factor really impacts the visibility in terms of what's in the pipeline or how we work with the sales teams in terms of forecasting. I've not noticed a difference, if you will, in close rates between a virtual machine and a physical machine.

Ken Xie: Yes, we probably would do some more deep study to maybe on Analyst Day, we'll give some color next year and also some midterm model on November 18 which also the 15 anniversary of IPO.

Operator: This concludes the question-and-answer session. I would now like to turn it back to Aaron Ovadia, Director of Investor Relations.

Aaron Ovadia: Thank you. I'd like to thank everyone for joining today's call. Fortinet will be attending investor conferences hosted by Deutsche Bank, Goldman Sachs and Oppenheimer during the third quarter. We will also be holding an Analyst Day on November 18 where we expect to update our medium-term financial model. The webcast link will be posted on the events in the Presentations section of Fortinet's Investor Relations website. If you have any follow-up questions, please feel free to contact me. Have a great rest of your day.

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

This article was generated with the support of AI and reviewed by an editor. For more information see our T&C.

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