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Fortinet Inc
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Fortinet’s Third Quarter Earnings Conference Call. At this time, all participants are in the 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.
And without further ado, I will now hand the conference over to your first speaker, Peter Salkowski, Vice President of Investor Relations at Fortinet. Peter, please go ahead.
Thank you, Eric. Good afternoon, everyone. This is Pete Salkowski, Vice President of Investor Relations at Fortinet. I am pleased to welcome everyone to our call to discuss Fortinet’s fiscal results for the third quarter of 2022. Speakers on today’s call are Ken Xie, Fortinet’s Founder, Chairman and CEO; and Keith Jensen, our Chief Financial Officer. It’s a live call that will be available for replay via webcast on our Investor Relations website.
Ken will begin today’s call by providing a high-level perspective on our business, then follow our – with a review of our financial and operating for the third quarter, providing guidance for the fourth quarter and updating the full year. We’ll then open the call for questions. During the Q&A, we ask that you please limit yourself to one question and one follow-up question to allow others to participate.
Before we begin, I’d like to remind everyone that on today’s call, we will be making forward-looking statements, and these forward-looking statements are subject to risks and uncertainties, which could cause actual results to differ materially from those projected. Please refer to our SEC filings, in particular, the risk factors in our most recent 10-K and Form 10-Q for more information.
All forward-looking statements reflect our opinions only as of the date of this presentation, and we undertake no obligation and specifically disclaim any obligation to update forward-looking statements. Also, all references to financial metrics that we make on today’s call are non-GAAP, unless stated otherwise. Our GAAP results and our GAAP to non-GAAP reconciliations are located in our earnings press release and in the presentation that accompany today’s remarks, both of which are posted on the Investor Relations website.
Ken and Keith’s prepared remarks today for today’s 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 will now turn the call over to Ken.
Thanks, Peter, and thank you to everyone for joining today’s call to review our outstanding third quarter 2022 results. Revenue for the quarter grew 33%, significantly outpacing the industry growth rate. We believe that customer recognition of the exceptional value proposition we provided by our high performance Forti-ASIC technology and integrated FortiOS operating system is driving our ability to take cyber security market share.
Product revenue growth was very strong at 39%, extending our position as a product revenue leader in the cybersecurity industry. Our product revenue performance reflects the strong demand we have built over the past 18 months across our security solutions along with the successful execution of our internal teams in managing the supply chain challenges.
Three growth drivers, the heightened threat environment, the convergence of security and networking, and the consolidation of security functionality and the vendors, together with the opportunity to upsell additional security services to our significant installed base are expected to drive future growth.
First, the threat landscape, including ransomware, continue to expand and evolving targeting companies of all size, location and industries. To counter the threat landscape, we are implementing our unique Universal ZTNA across a wide range of customers, driving triple-digit growth for this product and delivering a comprehensive approach to zero trust that is consistent for any user, anywhere, on any device and supporting today’s hybrid workforce.
Second, for years Fortinet has led strategies around the convergence of networking and security. We estimate the total addressable market for networking and security will increase from $54 billion today to $73 billion in 2026. Convergence accelerates digital transformation and substantially reduce operational costs by combining networking modernization with dynamic security that seamlessly span every part of the network, especially now that many companies are merging SOC and NOC operations together.
Fortinet is leading the convergence trend with a wide range of technologies including Network Firewall and Segmentation, Secure SD-WAN, OT Security, and 5G in a single operating system which can be deployed as hardware, software, cloud, and As a Service. Fortinet continues to gain Secure SD-WAN market share as our integrated Secure SD-WAN solution delivers better security, performance and efficiencies over more traditional offerings.
In the quarter, SD-WAN and OT bookings grew over 45% and 75%, respectively, and together accounted for over 25% of total bookings. We believe we can achieve number one market share in SD-WAN in the next couple of years.
Today, we announced the FortiGate 1000F, our latest innovation in converging networking and security. Powered by our new NP7 SPU, the 1000F delivers 5 to 10 times higher performance across six major network security functions while consuming 80% less power versus competitive solutions. The lower power consumption was a contributing factor in our top 2% ranking in S&P
Global Corporate Sustainability Assessment.
Our third growth driver is the consolidation of a vendors and product functionality. With Forti-ASIC’s huge computing power advantage, FortiOS can integrate more security functions than our competitors, together with over 30 key products ranging from endpoint to network to the cloud security. Fortinet provides our customers with easier operation while lower the management costs and the total cost of ownership.
Additionally, we are very focused on upselling value-added security services to our significant customer base. According to IDC’s second quarter unit share data, Fortinet hold a number one market share position for units shipped at 43%, up 210 basis points. We expect to reach 50% market share in the next few years. This leadership position and the substantial installed base creates attractive economy of a scale and the opportunity to upsell additional security services.
Before turning the call over to Keith, I would like to thank our employees, customers, partners, and suppliers worldwide for their continued support and hard work. Keith?
All right. Thank you, Ken, and good afternoon, everyone. Let’s start with an overview of our strong third quarter performance. Revenue of $1.15 billion was another quarterly record for Fortinet, increasing 33% year-over-year and 12% sequentially; our highest third quarter sequential growth rate in eleven years.
We continue to deliver better than industry average top-line growth and generate strong profitability. Our operating margin exceeded guidance at over 28%, driving the adjusted free cash flow margin to 40%.
Our history as a public company has revolved around the Rule of 40, measured as the combined total of revenue growth and operating margin. Impressively, the Q3 total came in at over 60. We continue to see success in our strategy for expanding further into the large enterprise segment. The number of deals over $1 million increased over 80% to 153 deals. The total billings value of deals over $1 million more than doubled driven by a record number of deals over $5 million, and G2000 bookings increased over 40%.
Our strong third quarter results reflect solid customer demand across both our Core and Enhanced Platform Technologies and the exceptional performance of the team in a challenging supply chain environment. We believe the investments we’ve made in building our platform and our go-to-market engine enables our customers’ digital transformation journey.
Our platform strategy allows customers to converge networking functionality with security capabilities while consolidating cybersecurity products, providing security across their entire digital infrastructure while lowering their operating costs. Recently, the Forrester Wave Enterprise Firewalls report acknowledged the success of our investment strategy, placing Fortinet as a leader for the first time in its history.
According to Forrester, “Fortinet excels at performance for value and offers a wide array of adjacent services. Long known for its bang-for-the-buck approach to network security, Fortinet has built a flexible and capable platform with its flagship product, the FortiGate Firewall."
Taking a closer look at the income statement, product revenue grew 39%. Product revenue growth for our Core and Enhanced Platform Technology products increased 29% and 51%, respectively. The product revenue growth rate accelerated over 4 points sequentially, especially impressive given it is our toughest year-over-year comparison in over 10 years.
Service revenue was up 28%, accelerating 3 points sequentially driven by strong product revenue growth and seven consecutive quarters that increased our term deferred revenue growth rates. Support and related service revenue was up 28%, accelerating over 2 points sequentially to $311 million. While security subscription service revenue was up 29%, accelerating 4 points sequentially to $370 million. Total revenue in the Americas increased 34%. EMEA revenue increased 37% and APAC posted revenue growth of 23%.
Total gross margin at 76.2% exceeded the high end of our guidance range. Product gross margin of 61% was up 30 basis points year-over-year. Services gross margin of 86.6% was flat year-over-year, but up 70 basis points sequentially. Operating margin of 28.3% was up 250 basis points, benefiting from FX and the operating margin leverage that comes with higher revenues.
Shifting to billings. Billings of $1.4 billion were up 33%, representing the sixth consecutive quarter of billings growth in excess of 30%. Core platform billings were up 27% and accounted for 67% of total billings.
As shown on Slide 6, we entry-level FortiGates posted very strong billings growth with the mix shifting 16 points in their favor, driven by demand and as we expected improved supply. Enhanced platform technology billings were up 45% and accounted for 33% of total billings, a positive mix shift of 3 points. Average contract term was flat year-over-year at 29 months.
Looking at the statement of cash flow summarized on Slide 7 and 8. Free cash flow was $395 million. Adjusted free cash flow, which excludes real estate investments, was $464 million, representing a 40% adjusted free cash flow margin. DSOs were down five days sequentially while increasing 12 days year-over-year to 75 days.
Cash taxes were $69 million. Capital expenditures were $88 million, including $69 million for real estate investments. We repurchased 10.2 million shares of our common stock for a cost of $500 million, bringing the year-to-date totals to 36 million shares at a total cost of $2 billion. The remaining repurchase authorization totals $530 million.
Regarding backlog, the backlog at the end of the third quarter was up slightly from the end of the prior quarter, with FortiGate Firewalls accounting for just one-third of total backlog. We expect fourth quarter ending backlog to be relatively consistent with the third quarter backlog as we are seeing early signs of a transition back to more normalized customer buying behaviors.
Moving to guidance. The current environment favors a Fortinet style platform that offers integrated solutions and strong security capabilities and an attractive cost of ownership. To enhance our ability to capture our share of the large market opportunity, we plan to continue to invest in innovation across our integrated platform offerings.
Now I’d like to review our outlook for the fourth quarter summarized on Slide 9, which is subject to disclaimers regarding forward-looking information that Peter provided at the beginning of the call. And to start, as part of the Q4 guidance setting process, we considered several factors, including the greater macro uncertainty today and with it, the increased risk of forecasting the timing of certain larger transactions.
The transition to more normalized customers buying behaviors, which means there is less of an emphasis on ordering to get a place online. And for comparison, in the fourth quarter of 2021, when supply was tighter, backlog increased over $120 million and contributed to 49% bookings growth.
And lastly, elevated year early year top line comparisons that include certain onetime items adding a couple of points of service revenue growth and fully cycling the Alaxala acquisition. In response, we have slightly widened our top line guidance ranges. For the fourth quarter, we expect to again reach the Rule of 60. And with that, the key metrics include billings in the range of $1.665 billion to $1.720 billion, which at the midpoint represents growth of 30%.
Revenue in the range of $1.275 billion to $1.315 billion, which represents growth of 34%. Non-GAAP gross margin of 75% to 76%, non-GAAP operating margin of 30% to 31%, non-GAAP earnings per share of $0.38 to $0.40, which assumes a share count of between $795 million and $805 million.
We expect capital expenditures of $75 million to $85 million. We expect a non-GAAP tax rate of 17%. And for the full year, we expect billings and revenue growth to exceed 30% for the second consecutive year. Billings in the range of $5.540 billion to $5.595 billion, which at the midpoint represents 33%, revenue in the range of $4.410 billion to $4.450 billion, which represents growth of 33%.
Perhaps for context, we should note at the midpoint, these full year billings and revenue growth rates are 3 points higher than the initial growth rates we provided in early February, despite the start of the war in Ukraine in late February, significant increases in interest rates and increasing uncertainty in the macro environment, and importantly, full year backlog is expected to be above the February estimate of $350 million.
Total service revenue in the range of $2.645 billion to $2.655 billion, which represents growth of 27% and implies full year product revenue growth of 42%. Non-GAAP gross margin of 75% to 76%; non-GAAP operating margin of 26% to 27% at the midpoint a year-over-year increase of 30 basis points. And again, for context, at the midpoint, gross and operating margin expectations were 50 and 100 basis points above the February guide, respectively.
Non-GAAP earnings per share of $1.13 to $1.15, which assumes a share count of between $800 million and $810 million. We expect full year capital expenditures of $325 million to $335 million. We expect our non-GAAP tax rate to be 17%. We expect cash taxes to be $265 million.
Before wrapping up, I’d like to offer some preliminary thoughts on 2023 and our midterm targets on the heels of a very strong set of growth in 2021 and in 2022. We continue to successfully balance growth and profitability, while investing in longer-term innovation and go-to-market initiatives to future growth. The strength of our business model includes its diversification, margins that provide capacity for future investment and a rich mix of higher-margin recurring service revenues.
As we saw in the highs of pandemic, the diversification helps mitigate the risk of economic slowdowns. Specifically, in 2020, we delivered operating margins of nearly 27%, adjusted free cash flow margin of over 38% and top line growth of 20%. And during the past 12 months, we have really exceeded our target operating margin targets, while increasing our engineering headcount by about 20% and significantly increasing our future sales capacity by over 25%, including a greater than 50% increase in new, non-tenured, salespeople.
While we will provide more detailed 2023 guidance when we report our fourth quarter results, it’s worth noting this revenue accounts for 60% of total revenue, with gross margins hovering above 85%. We see continued service revenue growth driven by two years of very strong product revenue growth and seven consecutive quarters accelerating short-term deferred revenue growth.
With a strong business model and the history of being able to execute, we are confident that our momentum will continue and point to our key growth drivers, including strategic investments, the heightened threat environment, the convergence of networking and security, the cybersecurity consolidation. Cyber securities are not immune to economic slowdowns is expected to remain a relatively safe harbor.
As such, we remain on track to achieve all of our medium-term financial targets from our May 2022 Analyst Day, including $10 billion in billings and $8 billion in revenue in 2025, each representing a 22% three-year CAGR from the midpoint of our 2022 guidance. The targets also included an average non-GAAP operating margin of at least 25% for the four years from 2022 to 2025 and a 2025 adjusted free cash flow margin in the mid-to-high 30% range. Illustrating our long-term focus for balancing growth and profitability, our targets remain committed to the Rule of 40 or better.
I’ll now hand the call back over to Peter to begin the Q&A.
Thank you, Keith. [Operator Instructions] Eric, we are ready for Q&A.
Excellent. [Operator Instructions] And our first question comes from Fatima Boolani at Citi. Fatima, your line is open.
Thank you. Good afternoon. I appreciate you taking my questions. Keith, this one’s for you, just with respect to the 4Q guidance and the outlook. I appreciate you kind of breaking down the three principal factors that went into that. But I wanted to dig in specifically on the comment you made about normalized buying behavior as it relates to the backlog build. So I think what I inferred from your comments is that while the backlog is going to be sequentially up and sort of higher than what you initially pointed out to be maybe $350 million of ending backlog. That’s certainly below the $500 million that you were previously telegraphing. So I just wanted to better understand sort of the modulation downward on backlog there and how the sort of normalized buying behavior contributes to that? And then I’ll ask my follow-up.
Okay. I think when we talk about normalized buying behavior, I think that we certainly saw some enterprise customers in the U.S. during the supply chain challenges. They were placing orders to get in line to hold their place in line for when the inventory is available. And I think I’ll say a year ago or so that, that was an appropriate behavior when there was a lot of uncertainty around the supply chain and maybe they’re planning what we’re going to do in 2022.
I think that somewhat in general now, and maybe Ken will talk more about this, I think people are getting is that the – certainly, we are, but the supply chain is a little bit easier to forecast and somewhat easier to manage. I don’t mean by any stretch easy, but I do think it’s easier. And with that, I think you’re starting to see the market drift back towards the emphasis start to what I would call more traditional buying, which is when they need it, they’re placing the order.
And also looking at the composition of our backlog, it’s only one-third or less related to our network security platform FortiGate more than half related to like a switch in AP, which is a networking equipment which is kind of an industry problem in the networking side because the networking device tend to be more changeable, more standard driven.
So a lot of customers, sometimes double, triple order try to get ahead of whatever the supply chain issue and also some of them can easily cancel once they got the product. So that’s why we feel probably keeping track in the backlog may not be the best way to forecast the business, and we should be more focused on security, security related, especially driving the future service based on huge FortiGate installation base.
Thank you. And Keith, just a clarification on the services revenue trajectory and more broadly thinking about next year. So we saw the reacceleration this quarter in services revenue. So wondering if you could give us a quick update on how the delayed registrations from earlier in the year and transactions from earlier in the year are trending and how we should think about that filtering and flowing into our models for next year? Thank you.
Yes. I think we’ve been messaging throughout the quarter at various conferences that – and even in the prior quarter that we had a clear expectation that service revenue growth has accelerated. So we’re very pleased to see that. I think there’s a number of things that are providing a tailwind into that.
Customer registering units is part of that. I think also the price increase is making its way first into orders and deferred revenue and now into the income statement. Keeping in mind that we have contracts at sometimes or as long as five years, that will give you a sense of how long the tailwind may relate to price increases as we will continue to cycle through renewals at old prices and replace them with new contracts. So I think we feel good about the direction of the service revenue and the margins that it provides, together with the fact that it’s 60% of our business.
Okay. Thank you. Our next question comes from Saket Kalia at Barclays. Saket, your line is open. Please go ahead.
Okay. Great. Thanks very much for taking my question here. Keith, maybe just to start with you. I’d love to just zero in on product revenue growth a little bit for this year. Can you just maybe talk about some of the growth drivers for product revenue this year that aren’t expected to repeat next year? Again, very helpful detail kind of thinking about total billings for kind of following years. But for product, what are some of the one-off things that we should be keeping in mind like in Alaxala like price adjustments, just to sort of think about what normalized growth in product might look as we start to think about the following years.
Yes. I think Alaxala is probably the easiest one to talk about in terms of providing numbers. We’ve talked about the fact that their revenue stream was probably something in the order of $130 million to $140 million when we acquired them and reminded people that they are a March 31 year-end, so their fourth quarter is a little bit off cycle. I think that it’s growth single digits. So I think that probably gives people a good level expectation reminder there that our interest in Alaxala is a lot to run at the IP and some opportunities that we have there to do things more longer term, if you will.
In terms of other unique things about product revenue in the quarter, I mean, I think that as the backlog comes into revenue as we go through the end of 2022 here and certainly into 2023 is tend to provide, again, a fairly significant tailwind to what the product revenue growth will be in 2023, assuming we get the drawn in backlog that we may see.
Yes. Also, we believe the growth driver, especially the converged network and security. We don’t think that’s a slowdown. We’ll be keeping driving the product revenue growth in the next 5 to 10 years. You can see the secure SD-WAN and OT both had a pretty healthy growth. And at the same time, we will continue to growth in the next 5 to 10 years in a huge market potential.
Got it. Got it. Maybe for my follow-up, really for both of you, I’ll make a jump ball here. I think in Q3, we had operating margins of about 28%. I think the guide for Q4 is for margins a little bit higher. When I think that long-term guide out to 25% of at least, it feels like you’re doing a lot better than that here in the near-term. Maybe the question is, how do you sort of think about that balance, right, in terms of growth, maybe moderating or normalizing as we mentioned versus sort of that long-term margin?
I think that’s where – if you look at the 13-year history, we as a public company, we always balance the growth and with the margin. So that’s where we feel the 25% above is a healthy margin and then we can also give the money to invest in the growth become a leader in the space. That’s where we’re continue to balance, but if the growth slowdown definitely will be more helping in the margin.
So that’s what we keep in saying the Rule of 40, probably in the last few quarters, we kind of even reached the Rule of 60 now. So that’s where also – when the growth slowed down and sometimes the service revenue has a higher margin, which can also help in the margin, but we do expect the growth will continue in the next few years with the three growth drivers I mentioned and plus additional service revenue to our big installation base, a lot of are not quite unable the security service revenue yet.
Yes. I would probably certainly agree with Ken operate just a little more detail on it. Keeping in mind that our – we sell in U.S. dollars, so there’s really not a direct FX impact there. On the revenue line, obviously, you can get into certain countries where the pressure on discounting, if you will, because of exchange rates can be a little more intense. But on the OpEx, because 30% of our business is in the U.S. and the rest is international. We do get a tailwind from OpEx from the strength of the U.S. And I think you’re seeing that in Q3 and you’re seeing that in Q4.
And probably why it’s important is that we’ve talked for a number of years now around and made reference to 25% operating margin. If you go back four years ago, five years ago, it was probably a target to get to 25% operating margin.
And since then, we’ve talked about averaging 25%, so I think a floor of 25%. It has certainly served us well as a way to help other people understand about how we invest in the business, and as Ken makes reference to it. As we have funds available over that 25% operating margin, it creates opportunities for some, not necessarily all that you’re seeing currently of those margin dollars to be reinvested back in innovation and back into our go-to-market strategy.
Got it. Very helpful. Thanks.
Okay. We’re just lining up the next question. And the next question comes from Hamza Fodderwala at Morgan Stanley. Hamza, your line is open. Please go ahead.
Hi, good evening. Thank you for taking my question. Keith, on the backlog, I appreciate, look, sometimes you have too many metrics that creates too many noise. And on the supply chain front, it seems like it’s getting a bit clearer. But could you give us any more granularity on how that backlog and that booking trajectory looked relative to your guidance, which I think when you guided to it, you were saying about 36% growth at the midpoint for bookings. So just curious how that shook out in Q3.
Yes. I think I’ll come back to kind of Ken’s commentary around backlog, which is really what kind of drives the conversation about bookings. I think a year ago, when we introduced the backlog metric, there was a lot of uncertainty around what the supply chain crisis was going to look like and how it might impact our business and the purpose of providing the backlog disclosure and the booking disclosure then was to kind of round out and help investors understand more about our business model as we go forward.
And as we heard in the question earlier from one of the questions, at the beginning of year, what kind of a swag – that kind of swag backlog growth of $350 million in the first quarter and then it came back and said, in the second quarter, maybe it’s going to get closer to $500 million for the full year. And now I think we’re looking at a number that’s going to be less than that, something in the floor probably seems reasonable from where we’re at.
And I think with net-net, the message there’s two messages to I think we’re becoming much more comfortable with our ability to execute in this environment and maybe some easing in the environment itself. And then secondly, I think that it was always our intention. I think we messaged this that these will be short-term metrics that we provide – and I think they’ve served us and our investors well for an extended period of time, but it’s probably time now that we feel that we’ve gotten a better control on it to bring us more – bring us back online, if you will, with what our industry competitors are disclosing and not disclosing.
Makes total sense. Just to follow up really quickly. I mean, is it fair to say that your bookings growth is still higher than your billings growth. Obviously, your backlog grew. So you’re still expecting underlying bookings to be higher than 30% this year.
Yes, we’re not going down to the detail of talking specifically about bookings, as I just mentioned going forward from our backlog, more than what we’ve given to this point.
Okay. Thank you.
Okay. Our next question comes from Rob Owens at Piper Sandler. Rob, your line is open. Please go ahead.
Great. Good evening. Thanks for taking the question. Just one from curious with the supply chain getting a little bit easier, how you’re thinking of about gross margin, both kind of in the short term as well as the medium term. Thanks.
I think the component and also the cost continue to go up. So that’s where – and also, we still have a pretty tight inventory to make most shipments shipping by air instead of by ocean. So that’s where – so we’ll keep it adjusted by all these costs and probably some of the wet ourselves, some of them we may do some price increase, but we also feel even some price increase, we continue to have a price advantage compared to competitive industry average with our own products. So that’s where the margin we feel probably will be more stabilized. And that’s probably the overall supply probably keep improving.
Yes. Ken, spot on with that. I probably a couple a little more granularity. I think if you maybe look at it between product gross margin and services gross margin, the product win is the one that’s probably more volatile related to what we’re seeing. We’ve certainly heard commentary that maybe things are easing a little bit, the chip manufacturers, but I would say that there’s no indication of any sort of cost reduction savings that are coming from either chip manufacturers or the component suppliers. So what we’ll see how that plays out.
Our strategy has been, and Ken alluded to this, is that we came into this economic cycle a year ago, believing that we had a price performance advantage and that we could raise prices and our target was really to pass along most but not all the price increases, call it plus or minus 1% margin. It’s kind of our target every quarter.
It doesn’t fall that way every quarter because of various variables. And I would imagine that to the extent that prices can remain to be elevated as we move into 2023, that’s kind of the starting point for our price strategy into 2023 as well, again, because we have not seen signs that we’ve lost the pro formas advantage. In fact, we continue to win that way.
Service is a little bit different. I mean, the largest cost component in services is labor. And if you look back, we’re a company that has its annual merit increase in the first or second month of the year, so you kind of get a rather immediate job on the COGS line from those – from the compensation increases, which is certainly appropriate and then you have to grow the service revenue into it. And I think that’s part of the conversation about why you saw the reference to sequential margin increases.
On the revenue side, it gets fairly complex. Well, maybe that complex. But thinking through how price increases that started about a year ago and kind of at a quarterly pace, if you will, how those price increases will make their way first on the balance sheet in deferred revenue and to what extent each item is going to reflect all those price increases and then how it will come off the balance sheet in future periods. So you will get tailwind from the price increases. And I would expect that particular tailwind should continue to, for an extended period of time.
Ken and Keith, thank you.
Okay. Our next question, just connecting the line now comes from Shaul Eyal at Cowen. Shaul, your line is open. Please go ahead.
Thank you so much. Good afternoon, guys. Keith, question on APAC, softest performance in, I think, like two years, what was driving that? And I have a follow-up.
Yes. I think we’ve made a leadership change there around the end of June, beginning of July, we had a retirement. And I think that’s just kind of the transition of leaders, if you will, is one was exiting into retirement and we brought so on. But I think we feel very, very good about in terms of their abilities. And I think the other part of it is you’re starting to see the lapping effect of Alaxala because all of Alaxala sitting in APAC. And so you’re going to see that now roll up on basically the full quarter comparisons that impact.
Understood. Understood. And on FortiGate sales, maybe looking at it from a tier perspective, it was slightly more mixed than prior quarters, entry level actually representing most growth versus the mid-range and high end. So any color on that front?
That’s where the – we see pretty strong growth related to the SD-WAN and OT, which more using the low end unit and at the same time, the supply chain improvements help a little bit. That’s where the – we’ll be able to shipping more product in the low line side. We still have some backlog in the middle high end, but it’s a low end had some improvement by redesign some of the products and also better supply chain right now
Yes. Ken talked about this in the past, the ability to introduce the new 70F product in the second quarter. We were a little bit hamstrung in Q2 and the beginning of Q3 even back into Q1 really on the low end. And I think we kind of messaged a bit in our conversations over the last quarter or so that we expected low end supply availability to really jump, if you will, in the third quarter, and we did see that. So it’s really more of a supply conversation in some ways as much as it is a demand conversation.
Thank you for the color. Appreciate it.
Okay. We’re just bringing our next caller live. Brad Zelnick from Deutsche Bank. Brad, your line is live.
Thank you so much and thank you for taking the questions. Ken, just a big picture question for you to start out with. You mentioned Fortinet success is in part coming from the industry trend of vendor and product consolidation. Why is Fortinet so well positioned as a platform for consolidation? And how does this inform your product and corporate development roadmap in terms of the need for even more product breadth to compete with other platform competitors out there that keep adding additional functionality.
I think we have a few unique advantage. The first from day one, we developed the FortiASIC, which have a huge companion power increase compared to using traditional CPU, but also FortiASIC also working side by side with the CPU. So that’s the huge computing power advantage comes from FortiASIC give us more computing power for the FortiOS to run more function, more security function including a lot of networking function. So that advantage is none of our competitors have that. So that’s making us keeping driving the market share and also the unit shipment, I mentioned, we like 43% of our market shareholder unit shipment there.
So that’s what we keeping – give us a long-term growth going forward because also on the convergence of security networking the secure computing power it must have a huge need to address both security and networking function there. Second is for the FortiOS is well integrate together with more function, leverage, security and power. So that’s also kind of a huge advantage for us compared to some other competitor, whether they have to use like a different blade or different functions. They have to go to some different parts or even to the cloud to address some secure computing power there. And then third one, we also have about 30 different products, mostly home developed and integrate, automate together.
So that’s also what helping drive we call the wider security fabric on called a mesh network. So that’s also helping the customer to lower the management cost and total cost of ownership. I think all these three factors we’re keeping driving Fortinet better position for the consolidation, both on the product functionality and also on different products into a single vendor platform strategy.
Ken, thank you for that. And it’s clearly working by your strategy. Maybe Keith just for you, you’ve disclosed quite a bit of information so much so that I have a very simple question that I just might have missed. But can you just very clearly explained for the reduction in the full year billings guidance for – that you’ve given us now the update on with these results. Thanks.
Yes. I think you’re talking about full year fourth quarter, one of the same at this point. And I would really just point to the macro environment and what we’ve seen really in the – over the last 90 days in terms of economic activity, if you will, I think when you look at how that manifests somewhat specifically, I think I’m getting a little more cautious in some of the forecasting of close timing on some of the very large deals. We’ve been very successful over the last few years. You saw some of the numbers about enterprise penetration with our growth in the enterprise.
The deals have actually gotten significantly larger as we’ve gone forward. And I think it’s appropriate in that environment to be a little more cautious on what we expect to close rates to be. The business itself is very healthy. If I look at the end of the spectrum, the small enterprise part of the business, for example, it actually outgrew the other two parts of the business in the last quarter by – it took about a point of mix, I think, from the other two. So I feel – feel good about the business, but just a little cautious about the macro environment as we go forward, how to forecast what’s coming from the sales team.
It makes total sense and in line with a lot of other data points that we’re all seeing out there. I guess just maybe as you think about what contributes to that, is there – it doesn’t sound like it’s anything competitive, but what are the customers doing? Are they shrinking deal sizes? Are they just taking more time and sweating out their existing assets? Any other color on that would be helpful. Thanks.
Yes. I don’t think we’re going to see deal sizes getting smaller one because we’re moving into the enterprise. If we were more established there and it was just kind of the same routine over and over, the fact that we’re growing in the enterprise, and again, you saw the numbers is going to by itself, increase our average deal size.
I certainly do feel that there’s caution is corporate America and the rest of the world is probably going through their budgeting cycles right now and looking at what they’re planning for, not only the end of 2022 and 2023. I think the other aspect of that, and again, I think this is fairly consistent with the other comments we’ve probably heard. I don’t think it’s a good time to really get in a position of forecasting some sort of significant budget flush in the fourth quarter. If it develops, that would be fantastic. But I think prudence is a little bit appropriate here.
It makes total sense to me. Thank you so much for taking the questions.
Thank you.
Thank you, sir. And next up, we have Shrenik Kothari, Shrenik from Robert Baird, your line is open. Thank you. Shrenik Kothari at Robert Baird, your line is open. Okay. We will move on to the next question. Please standby. Tal Liani at Bank of America. Tal, your line is open.
Hi, here is Madeline on for Tal today. Just two quick ones for me, and I apologize if this has already been mentioned or running between a few earnings right now. But just to be – just as Steve very pointed about it, last quarter, we heard bookings and bookings was a little bit softer than expected. This quarter, no disclosure in bookings. And again, I apologize, this was already mentioned. But just want to get, Keith, from your perspective directly, why no bookings for this quarter after a weaker quarter of booking last quarter.
Yes. We talked a link of this before you get on the call and for everybody’s benefit, I’ll just quickly kind of go through it. Yes, I think when we got into this conversation a year ago, we felt the backlog, which is really the driver of the bookings conversation was something that we thought was important to investors to understand and be able to track how we’re performing as a business and what they’re seeing in the drivers.
As we’ve moved forward, I think that if you fast forward a year later, I think we feel more comfortable now about some of the backlog forecasting. And earlier, we made reference that backlog may exit the year, something closer to 400 or a little bit north of that. And so with that in mind, I think we’re bringing ourselves back into what I would call industry norms, where nobody else really discloses this information, but we thought it was appropriate for the first year.
I would also offer one comment about backlog that’s important, and we get a lot of conversations around cancellation rates. Our cancellation rate has been extremely consistent at about 4% each and every quarter.
Also, the composition of backlog is kind of different now compared to one year ago, which is one year ago, I have to say, majority of that – related to the FortiGate and now FortiGate is less than one-third of the whole backlog and the majority of backlog that come from the switch and AP Wi-Fi, which is also kind of a more industry problem, which switch and AP more easily customer can change in different vendor compared to the security product, they have to design in, they have to a high switching cost. So that’s where we feel the backlog sometimes unpredictable and with the majority of come from switch and AP.
Got it. Thanks so much. And just one follow-up question there, too. I just mentioned having a little bit of prudence for going into next year and just your guidance. I’m also just wondering on the visibility side, are you seeing less visibility, the same visibility? Can you just talk to the trends that you’re seeing there in your pipeline?
I think the pipeline visibility is very good. And the pipeline growth is very strong. And I think that one of the things that we did at the end of the prepared remarks was, we went back to the 2022 mid-term guidance numbers that we gave, I think, a $10 billion booking company in 2025 and $8 million in revenue and margins of 25% or more and basically reiterated that. And I think we’re doing that which requires a 22% CAGR from this point forward. We’re doing that with the – after looking at our pipeline, looking at the strength of our pipeline so that it makes sense to us.
Got it. Thanks so much.
Okay. Getting ready for our next caller. Our next caller is Keith Bachman at BMO. Keith, your line is open. Please go ahead.
Many thanks. I also had two, Keith, to start with you. I wanted to go back to the billings commentary for Q4. Just on the revenue base is essentially the same, and therefore, it’s a DR impact that you’re guiding lower. As you mentioned that you’re expecting backlog to be less than the $500 million and maybe for in change.
Did some of that backlog, is it actually then flowing into the billings, and therefore, the billings guide down is even a little bit worse than it actually appears and any other context you could draw out on where specifically that billings weakness is Europe or what have you but if you could flesh those out, then I had a follow-up for Ken, please.
Yes. I want to be clear, we are expecting backlog to actually increase from Q3 to Q4, not significantly, but slightly, so.
Okay. So therefore, none of that backlog then is flowing into that billings in Q as anticipated, right?
Correct. I mean you’re always going to get some existing backlog that flows in the buildings, which you’re going to get new backlog, net-net, it’s going to be an add in total to it for the year. And I think the – and it’s a good question about Europe. I don’t want to – over that Europe form, you saw the revenue numbers and what we don’t disclose it. I would say the billings numbers Europe performed very, very well in the quarter and their pipeline remains extremely strong as we go forward.
Now we’ll see as we get through and get closer to 2023, and I certainly would really agree that there are certain tailwinds that are appropriate for Europe. But to this point, they’ve done it very, very well.
Okay. Ken, for you, then it relates to that very directly relates. As we think about Europe in calendar year 2023, the currency, as you alluded to, is a headwind. So I was just in Europe and customers view that the prices since you price in dollars have actually gone up quite a bit. So is there a risk?
Or how should we think about is there a risk of prices actually needing to come down because of the dollar-based pricing and therefore, the significant price increase, if you will, felt by the Europeans, is there a risk that prices need to come specifically down for currency next year? And/or would you see any risk more broadly, whether it’s currency or otherwise, whereby because supply and demand is coming back into balance sometime during CY2023 that there is some risk rather than getting price increases that we might be in a situation where prices actually start to move lower?
I think first about our price policies really, we – when there’s a cost increase like components another, we do like take some ourself. And then some others we probably have to pass the customer partner. But even with like price increase, we’re still leading the industry on the price performance on the functionality service. So that’s where so far we don’t see – in the last year because of pricing and actually, we’re keeping gaining market share because we have a leading price performance especially in a lot of what we call it convergence area and also like SD-WAN and OT is a very, very fast-growing area.
So it’s all our price advantage compared to competitors. And also, we do see a lot of potential to drive additional service because our service charge probably average about half of our some of competitor charging some are offer free, some are offer less, some are in sell as a bundle. So we do see a lot of potential growth area in the service, which also have a higher margin.
Okay. Okay. Thank you.
Thank you.
Okay. Just pulling up our next caller and it’s Gregg Moskowitz from Mizuho. Gregg, please go ahead. Your line is open.
Okay. Thank you for taking the questions. Keith, I know that you had experienced a bit of a pause in the first 10 days of June. With that in mind, how was linearity in the Q3 period? Were there any air pockets or anything that you would call out?
Yes. I don’t think – we didn’t see anything like we saw good question. We didn’t see anything like the two-week pause or10-day pause. We saw the first part of June in the Q3. I think that – when we look at linearity, you can see the DSOs, and I think it’s a pretty good reflection of where we’re at with linearity. It has not and probably will never be a 1/3, 1/3, 1/3 business in terms of linearity. You’re always going to get about 50% of your business in the final month of the quarter, but nothing really unusual about the activity there.
Okay. Thanks. And just as a follow-up, we’re getting quite a few questions about that billings guidance for the Q4. You outlined earlier to in response to Brad’s question, the cash list that’s sort of going into the Q4 guidance and the prudence with respect to the possibility for sales cycles to be elongated. I do just want to be fair, though, on that point. As it relates to the Q3 period and perhaps even the month of October, are you seeing any changes as it relates to average sales cycle?
We still have a very strong pipeline, actually stronger than before. And at the same time, we built pretty healthy, strong sales capacity to meet out the demand. Keith mentioned some tenure like we have about 50% of sales force actually has a tenure probably not reach the tenure yet, which we believe will become more productive in the next 6 months to 12 months, which also will helping drive the both the top line bottom line.
And just so I don’t if you can because I’ve already done that. So tenure is up about 50% in the people. That as a – we didn’t have a given a number, but it runs about 30% of the mix. So it’s a significant number of people that we increased that are starting new to the organization.
And that will make sense. I’m just wondering if there were any changes perhaps that you noticed that where might have been macro-related affecting sales cycles over the past 3 months to 4 months or so was as possible. It would just be very helpful to get a brief commentary on that as well. Thank you.
I just think that, as I said earlier in the conversation, as we started to see some – our deal size is getting larger in the enterprise, we’re certainly subject to more inspection perhaps than the eight-figure deals are started much more inspection than the seven-figure deals worth.
Yes. Okay. Makes sense. Thanks, guys.
Standby for our next question. Adam Tindle at Raymond James is our next caller. Adam, your line is open. Please go ahead.
Okay. Thanks. Good afternoon. Keith, I wanted to start to appreciate that you gave a little bit of color on 2023 on services growth acceleration, obviously, an exciting catalyst I think the flip side of that is we’re just kind of really unsure how to think about puts and takes to the other line item on product revenue growth. Not asking, obviously, for specific guidance, but I’m thinking about these tough comps. You just had very strong growth in one of the toughest comps that you’ve ever experienced in Q3.
Your exit rate billings is – guidance is coming down. I think there’s worry that the cancellation rates are at 4%, but could that ultimately increase with supply chain visibility. So a lot of fear on how bad product revenue growth could ultimately be and certainty on services revenue growth. So anything you could maybe point us to for a realistic view of how to think about puts and takes to product revenue growth in 2023.
Yes, kind of covering some old ground here. I don’t mean that negatively. One, I would just – again, the fact that we reiterated the mid-term guidance which is a 22% CAGR is probably a good indicator of how we think about it. I think that investors and analysts and ourselves are trying to understand the timing of when the backlog is going to reverse and actually go to the income statement and have an impact from product revenue.
And it’s going to provide – when it does happen, I think it will provide some elevated product revenue numbers as we look forward to it. Yes, I don’t have another point to that, and I kind of lost my train of thought. I apologize.
Yes. The growth driver we feel has not changed, like the convergence, like all the consolidation, also elevate like a threat environment. That’s how we’re keeping driving the product growth. And also – the service also I think the product revenue is really the leading indicator of service revenue. So it’s a pretty strong product revenue growth in the last two, three years we do see the service revenue continue to improve.
Yes. And I would come back and just talk a little bit about the cancellation rate comment that concern, again, it has been remarkably consistent at 4%, not suggesting there’s something there that would be a challenge. And certainly, I think the firewall part of that, which is roughly 1/3 is probably very specific to us and not really a commodity.
There’s other metrics provided in the past, and we can certainly kind of go through them again over 90% to 95% of all backlogs with existing customers. It’s not as if there’s people coming off to Street trying to order from us because they’re trying to double order or something like that. That’s just not plausible about it. And of what’s in backlog, I think, again, over 50% looking at Peter or not along with the – agrees with me, that’s been partially delivered. So it’s unlikely they’re going to cancel something.
So as a backlog got older, do we have more concerns about it. We watched aging a little bit. Yes, we did, but now we’re starting to see a bit of a plateau here in terms of what the backlog increases are and certainly some easing around to be on the horizon around the supply chain environment. So while we do watch the cancellation rates very, very closely, we are not seeing indicators of concern there.
Yes. I think one other stat. I think I’m recalling the numbers correctly, I have to look to stack up, but I think the top 20 deals in backlog accounts for like 8% of backlog.
Yes, that’s what it was. Yes.
Yes.
Got it. Maybe I can sneak in a quick follow-up. Just to get all the fear out there because aftermarket move suggests there’s a lot of fear. On from a billings basis, you’re mixing towards larger deals, which is obviously a good thing for the business, but your average contract term is flat at 29 months. A number of software companies are seeing durations decline in particular on those large multi-year deals. How do you think about potentially controlling for this so that duration doesn’t become a headwind to billings growth? Thanks.
Yes. I think as we continue to – we’ve said for several years that as we continue to expand into the enterprise segment, we expect that that’s going to bring with the longer-term contracts. And it has shown that. If you go a couple of years, I think average contract rates were closer to 24 months or 25 months, and you’re seeing that continued pressure.
And I absolutely continue to believe that as we continue to have success expanding the enterprise, and that continues to be a larger part of our business, it will continue to put a bit of tailwind, if you will, on average contract term. I think also SD-WAN has shown to clearly be a longer-term contract that when customers come to the party. So we’re not seeing that. I’m happy to see the last few quarters that we’ve kind of ended that 28%, 29% month and staying at that level. I was actually a little concerned that it was going to continue to grow and get into the low 30s.
Thank you.
Okay. We have our last question for the session. Michael Turits at KeyBanc. Your line is open, Michael.
Thanks. So to the extent you Ken, can you talk whether or not it seems realistic for backlog to continue to rise after this quarter? Or is that the point starts to go down, and at a fundamental level, where do you think we are relative to demand and, if you will, a refresh cycle around data centers that may have been neglected during COVID.
I have – probably were not using the refresh because I feel in the last like couple of years, some change in the network security landscape. So I probably more using the convergence, especially we see the strong growth SD-WAN, OT and also internal segmentation, other data center security which security is starting to deploy into the position traditionally network security, not deployed.
So that’s actually we plan most of the growth from that area. We do get into some big enterprise. They’re also looking at how do the consolidation like whether networking security, working with the other part of the infrastructure there. And we also see the very, very strong growth for our business in the big enterprise there also.
So that’s probably not the times really deploying to the new area and not only the environment is very, very fast and also a lot of like working from home remotely but also a lot of new areas drive a lot of new deployment. So that’s where probably we’re not kind of looking at refresh, replacing some of the old network security device, but it’s more in the new area we see will be – drive the growth for a very long time in the next 5 years to 10 years.
And Keith on backlog?
I’m sorry, backlog.
Yes.
I think the last quarter and maybe I think the fourth quarter it would – the inference would be that we’re at a plateau.
Still going to depend on supply, though, which is still the dynamic, but.
Yes.
Thanks.
Okay. At this time, I would like to turn it back to Peter Salkowski, Vice President of Investor Relations for closing remarks. Peter?
Thank you, Eric. I’d like to thank everyone for joining today’s call. Fortinet will be attending investor conferences hosted by Barclays, Stifel and Wells Fargo during the fourth quarter. Fireside webcast links will be posted on the Events and Presentations section of our website. If you have any follow-up questions, please [indiscernible] Thank you very much.
And this concludes our program. You may now disconnect. Thank you.