Fortinet Inc

NASDAQ:FTNT

Earnings Call Analysis

Investment in SASE and SecOps Fortifies Growth

The company has demonstrated consistent growth with service revenues hitting $869 million, a 28% increase, and a 27% three-year CAGR. A strategic shift toward higher-margin security subscriptions is evident with these now constituting 57% of service revenue. Gross margins have improved overall, but product gross margins have faced a slight decline due to inventory pressures. A surge in free cash flow and prudent spending led to exceeding operating income expectations. Key wins in SASE, especially a partnership with Google Cloud, are accelerating market penetration, suggesting strong potential for cross-selling. The company expects Q4 revenue to grow at the midpoint by 10% and projects continued investment in SASE and SecOps, with an optimistic view of achieving greater profitability and market share in 2024 despite prolonged sales cycle challenges.

Fortinet Q3 Performance: Overcoming Market Slowdown with Strategic Focus Shift

Fortinet, a leader in secure networking for over 23 years, faced a challenging Q3 with lower than expected product revenue, attributed to a diminishing growth in secure networking alongside hurdles in sales execution and marketing efficiency. Despite this, the company outperformed expectations in operating margin and free cash flow, shedding light on solid financial management and operational efficiency. A key strategic move in response to the market conditions was a shift in focus towards the Secure Access Service Edge (SASE) market, which is rapidly growing at a rate poised to outpace their traditional secure networking domain.

The Evolving Landscape of Secure Networking and SASE

The secure networking market, although experiencing a current lull, is valued at $62 billion and forecasted to grow to $86 billion by 2027. Fortinet remains optimistic about a return to double-digit growth in this sector. Complementing this is the company's foray into the security operations and SASE markets, expected to reach $78 billion and $36 billion respectively by 2027, with SASE growing at a remarkable 20% compounded annual growth rate. Fortinet is establishing itself as a unique contender in SASE by offering comprehensive services that integrate SD-WAN, firewall, and other security services underpinned by a unified operating system and Google Cloud partnership, granting them a significant competitive edge.

Financial Projections and Margin Goals

Looking ahead, Fortinet has set an objective to uphold a healthy operating margin of 25% or greater through 2024 and 2025. This goal aligns with their strategic pivot to focus on the higher-growth SASE and security operations markets, which currently comprise 20% and 10% of their business, respectively. This transition aims to rejuvenate Fortinet's top-line growth to the mid-to-high teens while maintaining robust profitability, an equilibrium they have successfully navigated in the past to achieve the lauded 'rule of 40' status.

Client Acquisition Success and Cost Management

The company's ability to attract new customers remains strong, as evidenced by the addition of over 6,400 new logos and notable 19% growth in bookings from small enterprise customers. Effective cost control measures further augmented Fortinet's financial success, pushing the operating margin to 27.8%, well above the guided range, and generating a 36% margin in free cash flow totaling $481 million. However, billings growth moderated to 6%, reflecting shorter contract durations and lower demand for appliances. Performance varied by both industry vertical and geographical region, with education and government sectors showing strength, while larger growth opportunities in Europe and the U.S showed signs of weakening.

Earnings Call Transcript 2023-Q3

[Operator]

Good day, and thank you for standing by. Welcome to the Fortinet Q3, 2023 Earnings Announcement. [Operator Instructions] Please be advised that today's conference is being recorded. I would now like to hand the conference over to Peter Salkowski, Senior Vice President of Investor Relations. Please go ahead.

[Peter Salkowski, executive]

Thank you, Ana, and good afternoon, everyone. This is Peter Salkowski, Senior Vice President of Finance and Investor Relations at Fortinet. I'm pleased to welcome everyone to our call to discuss Fortinet's financial results for the third quarter of 2023. Speakers on today's call are Ken Xie, Fortinet's Founder, Chairman and CEO; and Keith Jensen, our Chief Financial Officer.

This is a live call that will be available for replay via webcast on our Investor options website. Ken will begin our call today by providing a high-level perspective on our business. Keith will review our financial and operating results for the third quarter of 2023 before providing guidance for the fourth quarter of 2023 and updating the full year.

We'll then open the call for questions. [Operator Instructions] Before we begin, I'd like to remind everyone that today's call, we will be making forward-looking statements, and these forward-looking statements are subject to risks and uncertainties, which could cause actual results to differ materially from those projected. Please refer to our SEC filings, in particular, the risk factors in our most recent Form 10-K and Form 10-Q for more information. All forward-looking statements reflect our opinions only as of the date of this presentation more to take no obligation and specifically disclaim any obligation to update forward-looking statements.

Also, all references to financial metrics that we make on today's call are non-GAAP unless cited otherwise, our GAAP results and our GAAP to non-GAAP reconciliations are located in our earnings press release and in the presentation that accompanies today's remarks, both of which are posted on the Investor Relations website. Ken and Keith prepared remarks today for the earnings call will be posted on the quarterly earnings section of the Investor Relations website immediately following today's call.

Lastly, I'll reference to growth are on a year-over-year basis unless noted otherwise. I'll now turn the call over to Ken.

[Ken Xie, executive]

Thank you, Peter. Good afternoon, and thank you to everyone for joining our call. In Q3, we exceeded street expectations in our operation margin and free cash flow. However, building and product revenue fell below our expectation due to a slowdown in secure networking growth, along with challenging in sales execution and marketing efficiency. In response to the slowdown in secure networking market, we are shifting our marketing and sales team's focus towards a faster-growing secured operation as SASE market over the next few quarters.

How while maintaining our consistent focus on leading innovation in secure networking and the convergence of security and networking where we have been a leader for 23 years. While we anticipate limit ear-term growth in secure networking market, it is very important for Fortinet. As we believe, enable us our platform strategy with a massive footprint in the market leader as the market leader in both firewall revenue and units shipped. The secure networking market is valued at [ $62 billion ] and is projected to increase high single digits annually to [ CNY 86 billion ] by 2027. Our consistent focus on [indiscernible] our industry-leading DOS, which supported over 30 network function networking and security application combined with our ASIC-driven performance capability which provides flight to 10x better performance on average than competitors continue to drive our market share gains.

Secure networking remain a vital part of our strategy and a market that we believe will return to double-digit annual growth over time. We have been innovating for some time in the faster-growing segment of secure operations and SASE . Security operations also known as setup is a $46 billion market growing at mid-teens annually to $78 billion by 2027. Fortinet our platform is comprehensive and integrated offering EDR, SIM, SAR, MD and other integrated solutions. Consolidation in the security demand seamless integration and underlying secured tools. Fortinet strength lies in its innovation and its ability to enable automation through a high degree of product integration.

Our AI and product and power automatic stock business second, all underpinned by a single consolidated management and analytics platform. In addition to [ Secop ], we have continued to increase our focus on SASE. A $17 billion market expected to grow at a 20% compose growth rate to $36 billion by 2027.

We believe Fortinet is the only company with a SASE service solution that can perform all functions in the cloud or email and is on with a common operation system.

Including 4 networking and security set, market-leading SD-WAN, vWAN and the management council. Our SASE service solution is supported by Google Cloud. With over 100 worldwide SASE cloud location together with our own 30-plus point present and the data centers. For our client-based use case, we are salary SASE service function using our ASIC technology. For instance, we recently announced a Fortinet 1.8G with a security process a side. Which support our full SASE offering, which including SD-WAN, firewall, Secure SD-WAN gateway, big lock prevention and boost secure computing region 6 to 54x better than our competition. We anticipate that success in SASE market will first come from upselling SASE service to our installed base of tens of thousands of AT1 customers. And from attracting new customers looking to leverage a single-vendor integrated SASE service solution. Our industry leadership in both firewall and SD-WAN -- the 2 largest components of SASE provides us with a significant competitive advantage. We have a track record of successful execution and believe we are the only company with strong SASE service and the setup solution combined in the same operation system. This differentiation sets us apart and provide us with a significant competitor advantage over peers.

While we expect top line growth to be modest for the next few quarters due to challenging networking comparison and our business transformation realignment towards security operation and SASE . We anticipate growth return to double digits by the second half of 2024. We remain committed to generating healthy operating margin of 25% or greater in 2024 and 2025. Before turning the call over to Keith, I would like to thank our employees, customers, partners and suppliers worldwide for their continued support and hard work. Keith?

[Keith Jensen, executive]

Thank you, Ken, and good afternoon, everyone. As Ken mentioned, we are confident in our integrated 400S driven platform strategy, which is summarized on Slides 6 through 10 of the earnings slide deck. As we look forward, we believe shifting our R&D and go-to-market investments in the faster-growing SASE and SecOp markets is consistent with near-term market opportunities. As shown on Slide 10, SASE and SecOps account for 20% and 10%, respectively, of our business today.

And as shown on Slide 7, these markets are expected to grow in the mid- to high teens annually. Secure Networking, which currently accounts for 70% of our business, is expected to experience lower growth following 2 years of very robust growth. As a result, for the near term, we expect to deliver healthy profitability along with more modest growth. With execution and continued investment in the SASE and SecOps markets, we believe we can return to delivering mid- to high teens top level growth -- top line growth and while continuing to deliver operating margins of 25% or greater. In other words, a return to balance growth and profitability, which has led us to achieve the rule of 40 status in 12 or 15 years, as shown on Slide 19.

In a moment, I'll expand on the strategic shift by sharing a few of the tactical steps and investments. But first, I'd like to review some highlights from the quarter. We continue to add new logos at an impressive rate and saw top line performance in small enterprise and software was strong while operating margin and free cash flow were above expectations. We added over 6,400 new logos, supported by small enterprise customers, which grew bookings by 19%.

Our efforts to manage personnel and other costs drove our operating margin to 27.8%, 230 basis points above the high end of the guidance range. Free cash flow was strong at $481 million, representing a margin of 36%. Looking at billings. Starting from the third quarter of 2022, we saw a 3-year compounded annual billings growth rate or CAGR of 26%, illustrating our ability to drive strong and sustained growth over an extended period.

In Q3, however, billings of $1.49 billion represented growth of 6% as we experienced 1 month shorter contract duration and importantly, lackluster appliance demand resulting from elevated product growth in earlier periods. In terms of industry verticals, education and government buildings were strong, while service provider and retail buildings were weak. Small enterprise billings growth was strong, while growth rates with larger enterprises disappointed. Phil's growth varied by GEO with international emerging showing strong growth, while our much larger GEOs of Europe and the U.S. were weaker. Turning to revenue and margins. Total revenue of 16% Prometal revenue grew 16% to $1.33 billion, which compares to our 3-year CAGR of 27%. The 3-year CAGR was largely consistent with our 14-year CAGR illustrated on Slide 18. Product revenue of $466 million, representing a 3-year CAGR of 28% was down 1%, reflecting product lead times and backlog aligning with historical levels, and the lighter levels of network security demand can refer to.

Service revenues of $869 million grew 28%, representing a 3-year CAGR of 27%. Service revenue accounted for 65% of total revenues driven by 34% growth in higher-margin security subscriptions, which represents 57% of total service revenue. We mentioned the 3-year CAGR to illustrate how consistent they are. With the same CAGR starting from our 2009 IPO, which were illustrated on Slide 18, each of the 3-year CAGRs, billings, product revenue, service revenue and total revenue are within 5 points of the 14-year CAGR for the same top line metrics, adding to our confidence in returning to higher growth levels. Product gross margins were down 310 basis points as we saw margin pressure related to inventory levels. Service gross margin was up 60 basis points as service revenue growth outpaced higher levels of cloud and hosting costs. Total gross margin of 76.9% was up 70 basis points driven by the increase in service gross margins and the 6-point shift from product revenue to service revenue.

Operating margin of 27.8% exceeded the high end of the guidance range and operating income of $371 million was $33 million higher than consensus and $20 million above the high on the high end of our guidance range, reflecting our efforts to control spending. Looking to the statement of cash flow, summers on Slides 15 through 17. Free cash flow increased 22% to $481 million, representing a free cash flow margin of 36% or 9 points above consensus. Operating cash flow increased $68 million to 41% of revenue.

Capital expenditures of $70 million, including $50 million of real estate investments. Cash taxes paid in the quarter were $26 million. As a reminder, free cash flow benefited from regulatory relief in the form of deferred estimated and other tax payments in the second and third quarters, totaling $192 million and $18 million, respectively. In the fourth quarter, we expect cash taxes to total $345 million, including the $210 million of deferred tax payments. We repurchased 10.4 million shares of our common stock for an aggregate cost of $605 million in the third quarter.

In October, we purchased an additional 7.7 million shares for $444 million. And our remaining share repurchase authorization stood at approximately $980 million at the end of October.

Now I'd like to share a couple of key SASE wins for us in the quarter. In a 7-figure upsell win an existing financial services customer initiated their single vendor SASE solution for 50,000 users. Fortinet was able to displace another incumbent as the customer continue their consolidation journey with us, supplementing their earlier SecOps, cloud and network security purchases. And in a 6-figure deal, an existing SD-WAN customer continued their strategic transition to SaaS and cloud-based applications by adding our SASE solution for 2,000 users. We believe existing SD-WAN customers such as this one, offer a rich cross-sell opportunity for our SASE solution. It's worth noting these deals closed before our recently announced partnership with Google Cloud, which significantly expands our PoP coverage by adding over 100 locations and prior to Gartner's release of the inaugural single vendor SASE Magic Quadrant, where we were named a challenger. By 2025, 1/3 of new SASE deployments are expected to be single vendor. I should also note Fortinet is recognized in 9 Gardner Magic Quadrants as shown on Slide 3. Now I'd like to expand on Ken's strategic commentary with some of the tactical investments we're making to increasingly focus our efforts on SASE and SecOps in the areas of research and development and solution delivery, in addition to the new Google Cloud partnership I just mentioned and our own data center investments, we're continuing to integrate single SASE features into [ 40s ] and continuing to expand our SecOp capabilities with AI technology and additional functions in enhanced integration.

And finalizing co-development agreements with existing large enterprise customers to accelerate continuous improvement of our integrated enterprise level SASE solution. Our go-to-market strategy, our investments include actively promoting our challenger position in Gartner a single vendor SASE Magic Quadrant, focusing on third-party certification of our broad and integrated solutions. Including SSE and SD-WAN and aggressively marketing Fortinet competitive advantages and the key components of SASE, SecOps and network security as summarized on Slide 10.

Certifying 5,500 foot net sales professional of SecOps solutions after all ready certifying these same sellers in SASE, which is the largest sales enablement motion in company history.

Investing in sales comp plans to include incentives to sell SASE and SecOps capabilities to existing and new customers. Expanding partner roles deeper into channel partners specializing in SASE and SecOps.

And developing channel training and is focused on differentiating Fortinet's is comprehensive and integrated SASE and SecOps capabilities. We believe Fortinet remains well positioned in the cybersecurity market and the market shift to platform strategies is in early stages. According to Gartner, 75% of companies are pursuing a vendor consolidation strategy, reflecting the evolving landscape of cybersecurity in a highly fragmented industry with thousands of vendors.

As shown on Slide 9, Pertinent brings consolidation across SecOps, SASE and network security the 3 key growth drivers in our strategy. Organizations are recognizing that an integrated security solution with a single operating system is the best method to improve their security posture as this approach allows each security solution to share data and communicate with each other, reducing complexity and improving security effectiveness. Attending to piece together best-of-breed solutions from multiple vendors can result in slower AI-driven technology adoption, significant security gaps and a slower pace of identifying, reporting and resolving security incidents. Moving to guidance. we continue to see increased deal scrutiny and longer sales cycles, which is constraining our near-term results. We expect these longer sales cycles to continue along with the associated budgetary scrutiny, and our fourth quarter guidance takes us into consideration.

As a reminder, our fourth quarter and full year outlook, which are summarized on Slides 20 and 21, is subject to the disclaimers regarding forward-looking information that Peter provided at the beginning of the call. In the fourth quarter, we expect billings in the range of $1.560 billion to $1.700 billion, which at the midpoint represents a decline of 5%. Revenue in the range of $1.380 billion to $1.440 billion, which at the midpoint represents growth of 10%. Non-GAAP gross margin of 75.5% to 76.5%; non-GAAP operating margin of 27.5% to 28.5%. Non-GAAP earnings per share of $0.42 to $0.44, which assumes a share count of between 780 million to 790 million; capital expenditures of $40 million to $60 million; a non-GAAP tax rate of 17%. And cash taxes, as I mentioned, are [ $345 million ]. For the full year, we expect billings in the range of $6.095 billion to $6.235 billion, which at the midpoint represents growth of 10%. The Revenue in the range of $5.270 billion to $5.330 billion, which is the midpoint represents growth of 20%. Service revenue range of $3.355 billion to $3.375 billion, which at the midpoint represents a growth of 28%.

The service revenue guidance implies product revenue growth of 9%. Non-GAAP gross margin of 76% to 77% and non-GAAP operating margin of 26.5% to 27.5%, non-GAAP earnings per share of $1.54 to $1.56, which assumes a share count of between 790 million and 800 million. Capital expenditures of $220 million to $240 million; non-GAAP tax rate of 17% and cash taxes of $430 million. As we look forward to 2024 and transition from a period of elevated product growth, we can offer a few thoughts looking forward.

In the near term, we will continue to focus on improving profitability. We expect product gross margins to be pressured in 2024. Nonetheless, we expect healthy operating margins that are 25% or greater. We expect to gradually increase billings growth through the year and approach double-digit growth by the second half of 2024, reflecting the progressively easier comps due to the easing of the headwind and from backlog draws in the first half of 2023 and the benefit of our SASE and SecOps focus. We expect contract term to remain below our high water marks of 2022. We Consistent with prior years, we expect that the timing of service revenue growth trends will lag product growth trends. Longer term, we remain confident in our solutions and our ability to adopt our strategy to shifts in the market. taking market share as we increase our investments in SASE and SecOps, ultimately returning to balanced growth and profitability.

I look forward to updating you on our progress in the coming quarters. And with that, I'll hand the call back over to Peter to begin the Q&A.

[Peter Salkowski, executive]

Operator, [Operator Instructions] Operator, you can open the call for questions. .

[Operator]

[Operator Instructions] Our first question comes from Hamza Fodderwala from Morgan Stanley.

[Hamza Fodderwala, analyst]

Ken, maybe just for you. To what extent are you seeing SASE start to eat into firewall and network security budgets? Because clearly, there's a bigger focus there. There is a dedicated go-to-market effort there. So -- do you think that SASE is starting to cannibalize the firewall market to some degree?

[Ken Xie, executive]

I think it's a little bit different business model. SASE is more the service OpEx compared to the networking dip CapEx, during the slow economy environment, customers definitely move towards service-based OpEx. So it will be also since some of service providers kind of a little bit slower to adopt some of the SASE that -- we have been involved in SASE a long time. And some of the service provider kind of slower than we expected. So that's where we kind of changed some of the strategy more aggressively going ourselves at the same time, still working closely with the partner.

[Operator]

Our next question comes from Brian Essex from JPMorgan.

[Brian Essex, analyst]

I guess maybe, Keith, for you, as we look at the trajectory of product declines this quarter in billings growth -- and I guess guidance implies that this is a billings trough this quarter. What observations might you have from other, we'll call them, spending cycles where you've hit negative product or low single-digit product revenue growth and a degree of recovery that you've seen after those spending cycles? And what gives you the level of confidence in your ability to, I guess, return to double-digit growth for either product or billings or both in the second half, understanding you're going to have easier comps as well?

[Keith Jensen, executive]

Yes. Brian, great question, I should say. One of the slides that we added to the investor presentation for this earnings call actually maps out the what you can see is a cycle -- more cyclical nature of the business than maybe we've talked about in the past with product revenue. For example, in 2017, I think we had product revenue growth of 5%, and that was somewhat of a low watermark. The market may have been due and I think there's some analyst studies out there from other members of Wall Street that have kind of suggested that the market was due for a little bit of a pause in firewalls.

And I think we're seeing that now. And perhaps there was some delay of that pause because of supply chain issues and so forth, something that may have more naturally occurred in 2021 or in 2022. I think in terms of confidence, broadly, I think that was the intention of looking at the CAGRs and the success of the company that Canada has led the company through since its IPO and what those CAGRs are. And if you look at that combined with that new slide in the deck, you understand that there's going to be -- there has been the past been volatility in the industry and in the company.

But over the longer stretch, you see some very attractive CAGRs in that.

[Ken Xie, executive]

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

[Operator]

Our next question comes from Fatima Boolani from Citi.

[Fatima Boolani, analyst]

Keith, in your prepared commentary, you specifically called out the service provider and retail vertical perhaps exceptionally weak in their buying. And Ken was just sort of alluding to some of the challenges that are stemming from service provider buying behavior -- but I was hoping you could provide a little bit more detail as to why have the spending patterns in these particular verticals become so dramatically weak -- and was this in the scope of your assumptions as you were thinking about the pipe? Just wanted to get a better understanding of how and why the buying intentions have sort of rolled over in these 2 areas specifically?

[Keith Jensen, executive]

Yes. I think the service provider commentary has probably been reported by a number of other companies through this earnings cycle. I don't think that's -- the headline itself is not a surprise. I think the the significance of the slowdown in the service provider, at least for what we saw in our business was a surprise, particularly because it's a worldwide service provider number, not just in the U.S. But as I also noted in the prepared comments, we saw weakness in both the U.S. and the Europe, European markets. and that applies to service provider and to the retail sector. I think the retail sector probably is perhaps a little bit more prone to some of the digestion of SD-WAN projects that are still working their way through, and maybe that's a little bit different. .

As well as some of the economic headlines were probably a little bit disconcerting to the retail sector in the earlier part of the quarter.

[Operator]

Our next question comes from Tal Liani from BofA.

[Tal Liani, analyst]

Thank you. I have 2 questions on the same topic. If you go back to the last 2 years, you talked a lot about nonappliance sales, meaning upsell SD-WAN, which is a head on service and then non-FortiGate. And when things start to slow, we only blame the appliances. So the question is in retrospect, when you look at things, and you look at the other parts of the business and you look at the add-on sales and the other features, are they all based on you -- the ability of us selling appliances, meaning even if it's a non-FortiGate, it's being attached to a FortiGate sale, and that's why it's going down with it or an SD-WAN, et cetera. So first, just to understand kind of the total exposure of the company from all the successful products that you were able to sell over the last 2 years and now in retrospect, just to understand how is the exposure to appliance?

And the next -- the second question, which is related to it is if really it's about applying sales, what is the outlook for 2024 when it comes to do you have any big refresh cycle what could drive outside of easy comps that our comps are getting easier through the year? Is there anything that you're planning on your end to drive some kind of a replacement or a refresh of the appliances?

[Ken Xie, executive]

Yes, it's Ken. I think for SD-WAN, they do need a place to be in place to deliver all these SD-WAN functions there. We really offer SD-WAN as part of the [indiscernible] Function for free, and we started launching the SD-WAN service last quarter. So it's still in the ramp-up stage. We do believe one to all the service, we're keeping accelerating like like the SASE market will be growing faster than the secure networking market. I think that's where for certain like -- I think there's a chunk on the presentation shows some of the product and service, which is in on Page 19, you can see some of the cycle up and down there. .

Also, some of I do believe relate to the new ASIC and also product launch because we just started the new cycle of the new [ ISP5 we ] have a one or two product as starting launching, which gave us like a 5 to 10x better performance and more function at the same cost. Which also combined with the supply chain kind of elevated shipment of building in the last 2, 3 years. Because it's combined together, I feel have affected our price sales in the last few months. But I do believe this since we'll go back to normal probably in second half of next year. After the new product being fully launched after the supply digestion, but inventory directions kind of go through because we do see the long-term convergence story is still holding well. We have a big position with better integrated OS with salvation. And our plan as a part of the whole solution. It's a hybrid solution, both our part cloud, especially we call the universal SASE . So that's -- there's some kind of cycle, if you refer to the Page 19 of the presentation, we kind of probably go through that cycle right now.

[Keith Jensen, executive]

Yes, Tal, I'll maybe add to Ken's comments. I think you're correct in that, your interest that the vast majority of the time, our first sales to customers a firewall. It can be a virtual firewall or it could be a physical appliance. And really, that is the beachhead that then go sell these other security functions and products. I think what you're seeing is in part of the shift of strategy and we talk about making the investments in note SASE, but also SecOps. It's really that SecOps product family like EDR and SIM and so as such, that you're seeing is doubling down on the investments there because while it's not the largest of the 3 market segments, it is the fastest growing. And I think we have the opportunity to participate in those markets more, particularly now that some of our products have reached a greater level of maturity. .

[Operator]

Our next question comes from Saket Kalia from Barclays.

[Saket Kalia, analyst]

Okay. Great. Ken. I'm going to ask 2 together. So maybe for the first one, Ken, for you. Just maybe thinking about the long term and specifically in the SASE part of the business, when do you feel like Fortinet will have a solution that can compete head-to-head with other SASE solutions? Maybe the answer is now, right, but I just want to hear how you think about it. And how big do you think this part of the business can be longer term? That's the first question. The second question for you, Keith, is it's great to see the operating margin being. Maybe you could just talk about how you're thinking about sort of midterm profitability -- because clearly, the business can generate higher margins than 25%. How do you sort of think about that balance now kind of given some of the changes here?

[Ken Xie, executive]

Yes. The first answer is, yes, now we are ahead at competing. And we also believe we have a much better solution, better integrated and at the same time, much better cost ROI compared to other competitors of SASE. And also the universal SASE is very unique because they offer both in the cloud, on the plans of Compass all the same solution, which allows the customer a more like our solution instead of sometimes you have to deal with traffic, whether enough is office have to fold the part because our solution you can process some traffic locally on campus within their appliance.

[Keith Jensen, executive]

Yes. So you had a great point about whether you're talking about free cash flow, you're talking about operating margin. The company does very, very well on the bottom line. And the strategy has been to continue to reinvest that back robustly in both innovation in the form of R&D spending, but also in go-to-market, whether that's marketing, whether that's selling. I think we're looking at right now with the sort of firewall market. Obviously, we're trying to bring new solutions to better solutions to our sellers to sell when the firewall is a little bit slower. But I do think it's a workout conversation and looking at the sales coverage, if you will. We've talked for several years about how many -- in North America, for example, how many accounts do we want per rep. We started with 65, I think, 4 or 5 years ago. We were talking about that. That number is now down to 10. And at 10, you're probably reaching a point of where you're -- on the enterprise side, you're probably reaching a pretty good coverage model for our business.

You could probably go a little bit lower, but that feels pretty good. I think there's another opportunity right now immediately in front of us in terms of how do we continue to support our channel partners, be they distributors or be they resellers and make sure that we're getting the right level of mind share from them. So I would suspect there will be some investments in that part of the business as we go forward. At the same time, I think there's some opportunities here, and Ken's talked about it with us about how to be more efficient in how we're spending our money, whether that's in selling and marketing or back office functions or what have you.

So -- we're not trying to guide to 2024 today, obviously, but we did think that it was important to provide at least some early thoughts in terms of maybe a floor for what 2024 should look like for us on the bottom line.

[Operator]

[Operator Instructions] Our next question comes from Brad Zelnick from Deutsche Bank .

[Brad Zelnick, analyst]

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

[Ken Xie, executive]

We do believe in this fast-growing SASE SecOps market, the sales training, sales restructuring. At the same time, more efficient marketing is very, very important. And also, we are continue working closely with our channel partner with our distribution network to reaching more broad customer base. So we're also thinking the large cross-sell opportunity is huge and especially go through our partner network there. So I don't feel the investment we've made in the past will be any issue or kind of any slow us down. We do believe we are actually helping us to expand in this more service basis SASE market and also more consolidation secure approach.

[Keith Jensen, executive]

Yes. And I would just build on Ken's comment, Brad, and all good and fair questions. It's not by accident. We're talking about SASE. If you go back and think about it a little bit, we've been talking about it and in a number of different ways, Ken has talked about the PoP strategy, which now you see us accelerating that PoP strategy with the cloud providers to come to market more quickly. The Gartner Magic Quadrant, I think, of the catalyst for the single vendor strategy and having us in the challenger quadrant gives us the bonafides if you will, to have a lot of conversations.

The single vendor strategy, that installed base that you referred to, we went back and looked over the last 2 quarters, we've done several hundred SASE deals already. And to be quite honest, that was without any real wood behind the arrow in terms of marketing support and sales support. It was really just how it grew. And it's interesting. I would have expected those first sales that would have been clearly dominated by SD-WAN. They were not SD-WAN customers. They were often times, there were just as many brand new customers coming to us for the SASE solution as they were SD-WAN customers or somewhere and at the third part of the pie were customers that are bars for other firewall use cases.

So I don't -- in the expectation that our -- we're going to be successful initially in the smaller part of the market. I don't think we disagree with that. When I look at that same mix of SASE customers, nearly 50% of those SASE customers that we signed already would be in the SMB space. And then the remainder was kind of divided up between the larger enterprises and the mid-enterprise.

So I don't think we got here by accident. We maybe just not to talk about it publicly, but I think we're well positioned now because of the investments that we've made in the data centers, the PoPs, the operating system like Gartner Magic Quadrant, the fact in a single vendor in the installed base. I think this is the right strategic shift for us to make at this point.

[Brad Zelnick, analyst]

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

[Ken Xie, executive]

We do have a good partnership with Google. At the same time, some other service providers like digital royalty. And we also built some of our own like data center PoP over 30 owned by ourself, which has really given us a more cost advantage. So we're containing that strategy, but as do need time to ramp up. So Google is a very quick solution for us, for customers. And also, we feel we separate -- we kind of realign the market into 3 different segments. Secure networking, SASE and SecureOp is much clearer, much better lineup with the customer need and also with different customer demand. So that's much better, more clear compared to the previous one we have whether the FortiGate or some other like enhanced non-FortiGate product.

We feel this is a clear 3 segment line up quite well with the customer demand. So we're starting tracking based on this one, also we started compensate sales and the train sales and marketing along these 3 separate segments of the market. That will be more clearly to us internal for customers to a partner to very kind of drive what customers really need in the current environment.

[Keith Jensen, executive]

To Ken's point, look, we were -- last quarter, we were talking about 20 PoPs because we're building them ourselves, right? Now you're talking about over 100 locations, well over 100 locations. So I think there's a go-to-market opportunity there that this brings to us. I think longer term -- and we know that one of our competitors, this is the approach they take, and we have pretty good visibility, obviously, to what their margins are and their investments there.

And there's another player in the space that's much more building their own PoPs, if you will. PoPs individually are not huge things, right? I mean they are single-digit number of racks that really have a PoP, I think. So I do believe you need some forward-stage data centers. And I think that's consistent with our strategy that we've talked about, about increasing more and more hosted delivery services and particularly in SecOps. So I think this is not something that we're going to surprise people with in terms of our CapEx spending.

[Operator]

Our next question comes from Adam Tindle from Raymond James.

[Adam Tindle, analyst]

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

[Keith Jensen, executive]

Yes. I think we included a comment in the -- in my prepared remarks that the available -- we still have -- as of the start of the month, start of the week, I guess, we had $980 million of available authorization for the buyback. And I think you saw some of the numbers that we provided in the prepared remarks about being fairly aggressive during the quarter itself as well in terms of buying back stock. Canada so let me go shopping for companies very often. So I'll defer to him in terms of his thoughts on that.

[Ken Xie, executive]

We're definitely keeping looking. I think right now, the multiple probably more reasonable than the last 1 to 2 years. And also, we do realize the marketing also changing pretty quick. We'll continue to do the internal innovation. We feel we are the strongest on the internal innovation engineering among all the space, player. But on the same time, we also were open to looking for some other companies, which we can work together, join together.

[Adam Tindle, analyst]

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

[Keith Jensen, executive]

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

[Adam Tindle, analyst]

Any way to quantify it though?

[Keith Jensen, executive]

Quantify, no. .

[Ken Xie, executive]

Yes, we feel still in a healthy level, and we tend to keep about 6 months' inventory. That's where like when 2, 3 years ago, the supply chain should happen, we are in market position because also a lot of time, our customer need some urgent delivery of certain products. So we're probably still keeping the similar policy there. but also we're in a refresh cycle of our new products, especially end. I think so far, we -- I think we also kind of resurprised in the last 2, 3 years. now since starting to stabilize and so changing from a shortage a little bit more towards even some oversupplied. .

So we feel we are in a pretty good position because we more handle is operation manufacturer directly. So we handle it better than most of our other competitors on the inventory right now. Yes, we also don't see a big issue about the current inventory level.

[Operator]

Next question comes from Adam Borg from Stifel.

[Adam Borg, analyst]

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

[Ken Xie, executive]

Yes. We -- if you look in the last 2, 3 years, we're growing a lot of business also hired a lot of salespeople -- and the last 2, 3 years, we probably doubled the business. And at the same time, during the supply chain, you should somehow certain sales feel it too easy to get deal because as always a shortage of certain product there. So that's where we feel we need to enhance the training enablement and -- at the same time, I also need to be more disciplined about the performance.

So that's -- at the same time, we also -- when we're shifting this to more like a service-based SASE kind of consolidation cross-sell multi-cell secure part sales also need to keep in learning. At the same time, the market need to be kind of more efficient and also kind of a projection to the new growth opportunity. So that's the focus we have right now. So we are definitely keeping looking to be more efficient in both the sales and marketing going forward.

[Adam Borg, analyst]

Great. And what about the early feedback on [indiscernible] .

[Ken Xie, executive]

Yes, it's very good that give us a very quick start to match any other competitor on the location, number of [indiscernible] number up, and they also have a broad coverage, so it's a good partnership. At the same time, we continue to working with some other partners. We also will continue to build ourselves. And the long term, we feel we have more advantage than some of our competitors because we always have a strategy invest in some long-term or long-term investment strategy, including some real estate, some other parts, which give us a much better long-term return.

[Operator]

Our next question comes from Patrick Colville from Scotia Bank.

[Unknown Analyst]

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

[Keith Jensen, executive]

Let's try I'm following the math.

[Unknown Analyst]

I'm just trying to -- so last quarter, you guys gave some kind of like a forward look for 2024 billings. And if I remember rightly, the kind of forward look was expect exiting billings growth to be in high teens. Earlier in your kind of prepared remarks, there was a comment which was expect double-digit growth in the second half. I guess -- are we going from high teens to double digit? Is that the change?

[Keith Jensen, executive]

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

[Operator]

Our next question comes from Joseph Gallo from Jefferies.

[Joseph Gallo, analyst]

I've got a 2 parter, 1 for each of you. And Keith, as a follow-up to that last question, appreciate the commentary on bottom line floor for '24. Can you just talk about the methodology of top line guidance? Is this a rip the Band-Aid off guide? Or what underpins the confidence and visibility on a reacceleration of billings. Is it SASE turning on or just hardware digestion only taking 2 to 3 quarters? And then, Ken, given what you're seeing with AI, do you believe adoption of AI workloads eventually shift workloads back to on-premise and drives a higher need for firewalls long term?

[Keith Jensen, executive]

Yes. And I wasn't quite sure if the question was about the Q4 guide or the 2024 commentary about numbers.

[Joseph Gallo, analyst]

More for next year but both. Has the methodology for your top line guidance change following the past 2 quarters?

[Keith Jensen, executive]

Yes. I would say that, while we just deal with actually giving guidance for the fourth quarter, Absolutely. I think the assumed close rates, if you will, are dramatic. I think they're the lowest assumed close rates I've seen that I've used in over 5 years here for context. And they're obviously lower than what I saw in the -- what I used for the first half of the year. And I think that -- I would say there are indicators that the pipeline quality is better in the fourth quarter. But in given light of what we've done for the last 2 quarters, I don't think that should put much stock in that.

So I'm content to just assume a much lower close rate than I have more recently. 2024 are not really giving guidance. I think that, again, we're talking about buildings here and I know we're all aware of it, but really focus perhaps more on the impact of backlog and what it did to billings in Q1 of last year and Q2 of last year and how that eased throughout the year. So you're really going to see comps change I don't know that we're necessarily assuming a dramatic growth ramp of bookings, if you will, at this early stage for 2024. We do expect it's going to improve as we bring SASE online more successfully and secure operations. But I think it's really part of what you're hearing there is really getting clarity on how the backlog impacted 2023 numbers.

[Ken Xie, executive]

Yes. it's a very good interesting question about the AI and the security. I have to see definitely AI, we're starting kind of getting the security more quickly, both by that good guy bad guy. But in the genetic AI side, I feel, in some degree, the back a probably more leverage some of that one and the Protect side, still more using what we have been doing in the last 10, 20 years, more like a precision AI and make sure we block the type of not blocking traffic but also to generate -- also helping the porting cost and also helping the secure operation. So it's definitely the AI, we're keeping driving the security growth and both in the cloud and also our appliance.

We do see our plans also long term very healthy growth, especially we cause convergence of networking to networking security, especially in enterprise, in the compass environment. And we see that trend will continue to grow well, and our unique advantage leverage integrated ASIC will continue to lead in the market and keeping gaining market share. So long term, I don't see any slowdown of the appliance to get into the cybersecurity space.

[Operator]

Our next question comes from Gray Powell from BTIG.

[Gray Powell, analyst]

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

[Ken Xie, executive]

Yes. Actually, we do give the market growth for these 3 segments going forward. And we also believe we're growing faster than the market growth, gaining share in all the 3 segments. Related to the firewall FortiGate versus some other AP switch. We do see more headwind in AP switch for the AP switch because a lot of supply chain issues kind of pretty much over. And so it's -- so that's probably more headwind compared to the firewall secure networking for side.

[Operator]

Our next question comes from Eric Heath from KeyBanc Capital Markets.

[Eric Heath, analyst]

Great. And thanks, Peter, for getting me in here. Keith, just for you, curious how the economics to the top line for Fortinet change when a customer is kind of doing an apples-to-apples switch over from kind of the firewall customer over to SASE. And then secondarily, with the shift away from farewell, that probably means more of a shift to annualized billings. So curious how you're thinking about duration and that impact to free cash flow going forward?

[Keith Jensen, executive]

Yes. The second one is probably easier. I don't -- we have such a large footprint right now in the firewall business that it's going to take a while for any significant changes in the SASE billings if you really think about it coming into and having an impact on our total term. I don't know that we gave the number, but we know that we've come back to a more. We're coming down about a month year-over-year in terms of contract term in 2023 compared to 2022, we went from 28 months roughly last year to about 27 months this year. Maybe I could be off by a month. And you saw the impact in the financials. We've talked about that will one month impacts the billings number. I think it's going to take a while for SASE. As I mentioned, we've already done several under SASE deals. We expect to be more successful early on with 1 in SMB spaces and two, with our installed base. So I would imagine that but it's going to take a while to really have an impact on free cash flow.

[Ken Xie, executive]

Yes, we also will be keeping salaried training for internal sales force also to our partner for this new SASE SecOp operation, which is a little bit different than the traditional secure networking side. So that we also feel the -- with a huge installation base. We have SD-WAN firewall which we're leading. We're #1 pretty much in all this area, we feel the huge potential to upsell cross-sell the SASE and secure up once the sales force unevens the partner for the train.

[Operator]

At this time, the Q&A session has now ended. I will now turn the call over to Peter Salkowski for closing remarks.

[Peter Salkowski, executive]

Thank you, Anton. I'd like to thank everyone for joining the call today. Fortinet will be attending investor conferences hosted by Barclays, Stifel and Wells Fargo during the fourth quarter. Partially chat webcast link will be posted on the Events and Presentations section of the Fortinet Investor Relations website. If you have any follow-up questions, please feel free to contact me. Have a great day today. Thank you, Bo.

[Operator]

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