Fortinet Inc

NASDAQ:FTNT

Earnings Call Analysis

Fortinet Achieves Strong Growth and Raises Guidance in Q3 2024

In Q3 2024, Fortinet reported a 13% revenue growth to $1.508 billion, spurred by a 19% rise in service revenue. Notably, the company returned to positive product revenue growth after five quarters. Both operating and gross margins reached record highs, with operating margin up 830 basis points to over 36%. Looking ahead, Fortinet raised its full-year revenue guidance to between $5.856 billion and $5.916 billion, expecting service revenues to surge by around 19% to between $4.15 billion and $4.45 billion. The company also noted a continuation of strong demand for its SASE solutions, projecting five consecutive years of meeting revenue targets.

Strong Financial Performance Amid Growing Demand

Fortinet reported solid financial results for Q3 2024, achieving a total revenue increase of 13% year-over-year, reaching approximately $1.508 billion. This growth was primarily fueled by a remarkable 19% increase in service revenue, which accounted for 69% of total revenue, signaling robust demand for their offerings. In addition, product revenue turned positive for the first time in five quarters, growing by 2% to $474 million, highlighting a rejuvenation in their product sales following recent backlogs.

Record Margins Indicate Improved Profitability

The company’s operational efficiency is evident, as it achieved record gross margins of 83.2%, up 630 basis points from previous periods. The increase was attributed to a favorable mix shift towards higher-margin service revenue and higher growth margins in both products and services. Operating margins also reached a record 36.1%, indicating strong financial health and solid profitability, with adjustments showing consistent performance metrics even when factoring out occasional windfall gains.

Continued Leadership in Security Solutions

Fortinet's Unified SASE (Secure Access Service Edge) segment has shown impressive growth, with billings increasing by 14%. The fast-growing SSE (Secure Service Edge) technologies are driving extraordinary growth rates in their pipeline, with projections showing a 130% increase in annual recurring revenue (ARR). This success showcases the company's innovative approach and positions it favorably within a $284 billion total addressable market, as larger enterprises increasingly look toward vendor consolidation for security solutions.

Raising Guidance Amid Positive Momentum

The optimism surrounding Fortinet's performance is underscored by its revised guidance for the fourth quarter and full year. For Q4 2024, the company expects billings between $1.9 billion, representing a growth of approximately 5%, and revenue in the range of $1.56 billion to $1.62 billion, indicating a 12% growth at the midpoint. Total billings for the year are anticipated between $6.43 billion to $6.53 billion, with service revenues projected to significantly drive growth.

Acquisitions Contribute to Growth Strategy

Fortinet’s strategic acquisitions, notably that of Lacework and Next DLP, are enhancing its market position, adding approximately 60 and 90 basis points respectively to Q3 billings and revenue growth. These acquisitions not only expand Fortinet’s service offerings but also strengthen its operational metrics, with gains observed in gross and operating margins that correlate to these expansions.

Key Wins and Market Expansion

Fortinet has secured several notable contracts, including upsell deals in retail and healthcare that underscore its competitive edge in simplifying security management and driving cost efficiencies. The surge in customer demand for Fortinet's solutions across various verticals illustrates the company's effective strategy to penetrate sectors that are often slower to embrace digital security transitions.

Outlook and Anticipated Market Trends

The company anticipates upcoming growth cycles driven by a series of upcoming product refreshes in the firewall market, expected to start in 2025. Fortinet’s leadership in the SASE market is projected to solidify, as they leverage their foundational strengths in networking security, putting them ahead of competitors who rely on multi-vendor solutions. Vertical markets such as manufacturing and retail are also anticipated to see consistent growth, fostering a bullish outlook for the company as it navigates the evolving landscape of cybersecurity.

Earnings Call Transcript 2024-Q3

[Operator]

Good day, and thank you for standing by. Welcome to the Fortinet Q3 2024 Earnings Conference Call. [Operator Instructions] Please be advised that today's conference is being recorded.

I would now like to hand the conference over to your first speaker today, Aaron Ovadia, Senior Director of Investor Relations. Please go ahead.

[Aaron Ovadia, executive]

Thank you, and good afternoon, everyone. This is Aaron Ovadia, Senior Director of Investor Relations at Fortinet. I am pleased to welcome everyone to our call to discuss Fortinet's financial results for the third quarter of 2024. Joining me on today's call are Ken Xie, Fortinet's Founder, Chairman and CEO; Keith Jensen, our CFO; John Whittle, our COO; and Christian Agard, our CAO and sales operations leader.

This is a live call that will be available for replay via webcast on our Investor Relations website. Ken will begin our call today by providing a high-level perspective on our business, Keith will then review our financial and operating results for the third quarter of 2024 before providing guidance for the fourth quarter of 2024 as updating the full year. We will then open the call for questions.

During the Q&A session, I 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 that we will be making forward-looking statements, and these forward-looking statements are subject to risks and uncertainties, which could cause actual results to differ materially from those projected. Please refer to our SEC filings, in particular, the risk factors in our most recent Form 10-K and Form 10-Q for more information.

All forward-looking statements reflect our opinions only as of the date of this presentation, and we undertake no obligation and specifically disclaim any obligation to update forward-looking statements.

Also, all references to financial metrics that we make on today's call are non-GAAP, unless otherwise stated. Our GAAP results and 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 our Investor Relations website. The prepared remarks for today's earnings call will be posted on the quarterly earnings section of our Investor Relations website following today's call.

Lastly, all references to growth are on a year-over-year basis unless otherwise noted.

I will now turn the call over to Ken.

[Ken Xie, executive]

Thank you, Aaron, and thank you to everyone for joining our call. We are pleased to report another quarter of strong execution and continued growth momentum, including record gross margin and operating margin with operation margin increased by 830 basis points to over 36%. Total revenue growth of 13% as we returned to positive building and product revenue growth. Unified SASE building growth of 14%, secure operation building growth of 32% and secure networking returned to positive growth all driven by a continued share gain in our total addressable market of $284 billion. As highlighted on Slide 11 of the investor presentation, Fortinet continued to be the only vendor to leverage a single operating system for the U.S., delivering solution with 5 secure network in dynamic quality report, secure service edge, SD-WAN, single vendor network firewall and Enterprise wireless line infrastructure. For the U.S., combined with proprietary for ASIC technology significantly boost secure computing power delivered 5x to expect performance than our competitors while lower customers' total cost ownership and energy consumption.

In the third quarter, Unified SASE building was 23% of our business, up 1.5 points, driven by secured building growth of 220 with pipeline up 130%. Fortinet is the only vendor offering all SASE functions in a single operation SIM and providing a unified networking security stack on-premise and in the This allows FortiSASE to be deployed within minutes from our SD-WAN customers.

Our SBS-based FortiSASE also enable sovereign SASE for service providers and large enterprise to deploy FortiSASE with their own data center for data privacy. In addition, we were recently recognized as a clear leader in the 2024 government magic quadrant for SD-WAN for the fifth consecutive year and notably position highest of all vendors in ability to execute for the fourth year in a row, leveraging leading position in firewall and SD-WAN and our integrated FortiSASE within the same FortiOS, provide easiest and most secure path for migrating from traditional firewall to secure SD-WAN and Unified SASE.

[indiscernible] invest in our global infrastructure over 3 million square feet of across office space, briefing center, operation facility and data centers. Our own hosting capability gives us a long-term cost advantage were allowing us to use our own Fortistack for better security and management.

security operation was our fast-growing pillar outpacing the overall market with a 32% building growth, accounting for [ 10.5% ] of our total business, up 2 points. We have expanded our secured operation portfolio with the launch of [indiscernible] which together represent a new $20 billion market opportunity. And we expect to cross-sell both solutions to a large installed base of customers.

Our commitment to innovation and investment in R&D has enabled us to rapidly expanding FortiAI, our GenAI system into 7 key solutions. FortiAnalyzer, FortiManager, FortiSIM, FortiDLP, and recently announced FortiNDR and FortiCNAPP. GenAI for FortiAI will be announced in early 2025, as Fortinet AI-based secure operation business are accelerating.

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 Jensen, executive]

Thank you, Ken. Thank you, Aaron, and good afternoon, everyone. Let's start with the key highlights from the third quarter. We are very pleased with our strong execution and financial performance in the third quarter, repeating our second quarter performance by again achieving record gross margins and record operating margins while delivering top line results at the top of our guidance range. Total revenue grew 13%, driven by strong growth in services revenue and product revenues returned to growth. We again added over 6,000 new logos driven by the resilience of small enterprise customers and the strength of our robust channel partner, As you'll hear in a moment, we are pleased to again raise our revenue and operating margin guidance for the full year. And we believe we are on track to achieve our seventh consecutive year of exceeding the rule of 40.

Looking at billings in more detail, RPO grew 15% to $6.1 billion, and total billings grew 6% to $1.58 billion, driven by robust growth in security operations at 32% and Unified SASE at 14%. SSE and related cloud technologies, were again the fastest growers in Unified SASE, benefiting from our large SD-WAN customer base. Our Unified SASE and security operation pillars are gaining considerable traction with over 50% of their billings coming from our secure networking installed base and combining to drive our SaaS solution, organic ARR growth rate of 74%.

The customer buying journey from FortiGate to SD-WAN to SASE supports our customers drive towards consolidation and is gaining traction. This consolidation journey first begins with a firewall in 40 OS and typically expands to SD-WAN and next to SASE. I should share that 2/3 of our large and mid-enterprise customers have deployed our SD-WAN technology, providing them with a gateway to FortiSASE. These are our customers, our first year of SASE delivered high mid-single-digit penetration rates, highlighting both the dramatic expansion opportunity as well as customer demand for vendor consolidation.

Including all elements unified SASE, pipeline growth was over 30%. And while the SSE technologies are seeing pipeline and ARR growth of 130% and over 500%, respectively. Larger enterprises continue to drive our expansion into Unified SASE and the security operation markets with large and mid-enterprises representing 91% and 76% of SASE and Secop's billings, respectively.

As we work through the wind-down of last year's backlog and the related year-over-year headwind to growth this year, secured networking has returned to growth as we expected. Rounding out the buildings commentary, SMB and large enterprise were our top 2 performing customer segments, while EMEA was our best-performing geography with double-digit growth.

Among our top 5 verticals, manufacturing billings grew by over 20%, driven by OT billings of 119%. Retail returned to growth for the first time in 6 quarters, up 9%, while the service provider vertical reached its highest growth rate over that same 6 quarter period.

Turning to revenue and margins. Total revenue grew 13% to $1.508 billion, driven by 19% service revenue growth and product revenues returned to growth. Service revenue of $1.034 billion grew 19% accounting for 69% of total revenue. Service revenue growth was driven by growth in our SaaS solutions, including 50% services growth in SecOps and 27% services growth in Unified SASE. Product revenue returned to growth for the first time in 5 quarters, increasing 2% to $474 million.

Excluding the impact of backlog, product revenue grew sequentially at double-digit rates, outpacing historical norms for Q2 to Q3. And following a similar storyline on what we saw in Q2, with sequential growth also outpaced historical norms. A moment ago, we talked about solution consolidation and describe the customer's journey around firewalls to SD-WAN and on SASE. The second customer buying journey is supporting customers' convergence of security and networking. Their journey begins with Fortinet firewalls and expand to leverage our FortiLink technology to manage Fortinet switches and access points. It's worth noting that over 95% of our larger enterprise customers previously or simultaneously purchased FortiGate firewalls.

At the same time, our switch penetration rate for these larger customers is around 50%, highlighting both our success and the future opportunity. Software license revenue continued its double-digit growth, driven by SecOp Solutions and represented a mid- to high-teens percentage of total product revenue. Combined revenue from software licenses and software services such as cloud and SaaS security solutions, increased 33%, accelerating from 32% in the second quarter and providing an annual revenue run rate of over $900 million.

Total gross margin increased 630 basis points to a quarterly record of 83.2%, exceeded the high end of our guidance range by 320 basis points. Gross margin benefited from higher product and service growth margins as well as a 4-point mix shift to higher-margin service revenue. Product margin of 71.6% was also a quarterly record and increased 1,370 basis points, which includes a 320 basis point benefit related to the renegotiation of supplier contractual commitments.

Excluding this onetime benefit, the product gross margin would have been [ 6.4% ]. Service gross margin of [ 88.4% ] increased 130 basis points as service revenue growth outpaced labor cost increases and benefited from a mix shift towards higher-margin FortiGuard security subscription services.

Operating margin increased 130 basis points to a quarterly record of 36.1% and was 360 basis points above the high end of our guidance range. Excluding the onetime benefit to product gross margins, operating margins would have been 35.1%. Taken together with our reported Q2 margins, the Q3 margins, excluding the onetime benefit, provide directional insights to our financial performance.

Before moving on to the statement of cash flows, I'd like to provide a few details related to the impact of Lacework and next VLP acquisitions. These acquisitions increased Q3 billings and revenue by approximately 60 and 90 basis points, respectively, and increased gross and operating margins by about 30 and 220 basis points, respectively. And as most decreased gross margin and operating margins.

Looking at the statement of cash flow summarized on Slides 16 and 17. Free cash flow was $572 million, representing a margin of 38%. And adjusted for real estate investments, the margins came in at 40%. In the first 9 months of the year, free cash flow was $1.5 billion or $1.75 billion after adjusting for real estate investments.

Cash taxes were $140 million, up $114 million, reflecting the prior year's regulatory extensions of estimated tax payments. Infrastructure investments totaled $36 million. The average contract term in the third quarter was 28 months, flat year-over-year and quarter-over-quarter. DSO decreased 6 days year-over-year and quarter-over-quarter to 62 days, reflecting stronger than usual linearity.

The $106 million gain on bargain purchase from the Lacework acquisition relates to NOL carryforwards and the related recognition of the deferred tax assets. The gain is excluded from our non-GAAP financials, but it is included in the GAAP financials, adding $0.14 per share to our GAAP EPS. Share buybacks in the quarter totaled $600. And last month, the Board increased the share repurchase authorization by an additional $1 billion, bringing our remaining share repurchase authorization to approximately $2 billion.

Now I'd like to share a few significant wins from the third quarter. First, in a 7-figure upsell deal, an existing SD-WAN customer in the retail industry, continued their consolidation journey, adding FortiSASE for 16,000 users. This customer selected our FortiSASE solution for simplicity, ease of management and consistent security enforcement across our infrastructure. We outperformed the competition by leveraging our FortiOS operating system. Streamlining operations and reducing cost of ownership while showcasing our ability to consolidate multiple security functions onto a single platform.

In another 7-figure win, a medical device company purchased FortiSASE to replace their existing solution. This customer chose Fortinet we simplified and consistent security management, significant cost savings and FortiSASE's enhanced functionality, particularly the bidirectional connectivity between their data center and remote users, enabling to push policies more effectively.

In an 8-figure competitive displacement win, a multinational bank commenced their partnership with us by selecting our FortiGate firewalls and multiple set top solutions to secure their hybrid architecture. This customer was particularly impressed with our integrated security end-to-end visibility and automated response capabilities of our FortiOS operating system.

Before discussing our guidance, I'd like to offer a couple of comments on the firewall recovery and refresh opportunity. During last quarter's remarks, we mentioned that the continued improvement in the days of registered FortiGuard contracts indicated the inventory digestion at end users was returning or had returned to normal. In the third quarter, this metric was stable, further validating our view that the firewall market is recovering. Today, we'd like to add to this commentary by noting that in 2026, a record number of FortiGates will reach the end of their support life cycle, and we expect these customers to start to refresh cycle for these products sometime in 2025.

Moving on to guidance. As a reminder, our fourth quarter and full year outlook, which are summarized on Slides 19 and 20, are subject to the disclaimers regarding forward-looking information that Aaron provided at the beginning of the call. Before reviewing our outlook, I should note, we expect Lacework and ex DLP for those acquisitions, Q4 billings and revenue by 75 and 135 basis points, respectively, and decreased audit margins by 230 basis points.

All right. For the fourth quarter, we expect billings between $1.9 billion and [indiscernible] which at the midpoint represents growth of 5%. Revenue in the range of $1.56 billion to $1.62 billion, which at the midpoint represents growth of 12%. Non-GAAP gross margin of 79.5% to 80.5%; non-GAAP operating margins of 33% to 34%; non-GAAP earnings per share of $0.58 to $0.62, which assumes a share count of between $768 million and $778 million; capital expenditures of $100 million to $120 million; a non-GAAP tax rate of 17% and cash taxes of $127 million to $177 million.

For the full year, we expect billings in the range of $6.43 billion, to $6.53 billion; revenue in the range of $5.856 billion to $5.916 billion, which at the midpoint represents growth of 11%. Service driven in the range of $4.15 billion to $4.45 billion, which at the midpoint represents growth of 19%. Non-GAAP gross margin of 80.3% to 81.3%, non-GAAP operating margin of 32.9% to 33.9%, non-GAAP earnings per share of $2.20 to $2.28, which assumes a share count of between $766 million and $776 million.

Capital expenditures of $380 million to $400 million, non-GAAP tax rate of 17% and cash taxes of between $550 million and $600 million.

I look forward to seeing you at the Analyst Day later this month and updating you on our progress in the coming quarters.

I'll now hand it back the call over to Aaron to begin the Q&A session.

[Aaron Ovadia, executive]

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

[Operator]

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

[Hamza Fodderwala, analyst]

Ken, I couldn't help another thing in your investor presentation, you talked about a market that you see over $200 billion, growing 12% over the next 4 years. Obviously, a big chunk of that growth is driven by the SASE market and your share in there. I'm curious if you could talk a little bit more about Fortinet's approach in terms of Sovereign SASE. How is that differentiated versus some of the competitors out there? And what is it that you're doing differently, particularly for those highly regulated verticals out there?

[Ken Xie, executive]

Thank you, Hamza. It's a great question. We invest in the SASE for 5 to 10 years in the market, including our SD-WAN and also all the SASE function in the same FortiOS, both on-premise also in the cloud. So with huge differentiation without a competitor, which they cannot run the SASE whether in the same OS or even different box. And that's for the sovereign SASE. We us call private SASE, actually -- if you look at probably 1 year ago, we were more focused on there with a lot of service provider, which is quite important for them to play the SASE within own data center to process data and also to keep the data in their own kind of data center and also process also within our own data center. So that's the 2 important factor there. So they have to be local and to secure the data and same kind of pro data locally, so that's a huge advantage in the same OS and also a lot of function can use in FortiASIC salary. The other differentiation comes from the business side. So we are the #1 on the network security firewall. We're also the #1 on the SD-WAN. So leverage our installation base and also both the firewall function and also IT function the same OS with the SASE. So that for the customer, they have the most easy migration part from the traditional firewall vendor, I mean some traditional firewall customer to the SD-WAN customer go to SASE. It's only in a few minutes reconfiguration that can enable SASE based on their previous SD or the firewall contribution there. So it's a very easy migration path.

As you can see, the pipeline growth and also the business is growing there from SSE like over 200% the pipeline grew over 100%. So we do believe we'll be the #1 leader in the assays in the next few years.

[Operator]

Our next question comes the line of Brian Essex from JPMorgan.

[Brian Essex, analyst]

Stick to one topic. I guess either Ken or Keith, could you dig into the commentary around the firewall refresh cycle that you provided. So with respect to conversations you're having with customers, and maybe with a little bit of color what you've seen historically, how far before the renewal point do customers tend to refresh? And do you have any insight into the mix of F&B, large enterprise service provider, retail and what the timing and the magnitude might be, whether this might be a first half event, second half event? Any kind of insight you could provide would really be helpful.

[Keith Jensen, executive]

Yes, I'll kind of jump in a little bit on this. I think that we see these end-of-life of these products starting in the second half of 2026. We don't expect the customers to wait until the 11th hour to make the change. For larger enterprises, they would go through another certification POC project perhaps as part of that before they place them in service. So we saw a similar -- not similar, we saw a lift, if you will, similarly in 2023, although the magnitude in 2026 is much, much larger. And why it's relevant to 2023 is that if you go back and look at product revenue growth in 2022, very different world, supply chain, switches, et cetera, but I think in 2022, the product revenue growth was a little bit over 40%. So we do think there's a relationship there. We do think it starts earlier.

To the second part of your comment, as I mentioned, the absolute number that we see in 2026 is by far the largest we've seen probably ever, but certainly in the last 5 or 6 years. It is -- each year is dominated by the entry-level firewalls. However, in 2026, we do see a significant portion of that actually being in the mid-range firewalls as well. And that is a very unusual and positive situation. I don't have right -- I would break down by SMB or something else. So maybe, Christian, do you want to offer something more on that.

[Brian Essex, analyst]

Or by vertical, I think you've mentioned before that you need large enterprise retail and service provider in order to recover. So if you have any insight there, how that -- how their cycles and spending patterns may impact, that would be helpful.

[Keith Jensen, executive]

Well, again, I think 2022 was a robust year for those industries that you just talked about retail in particular and partly manufacturing across the board. And I would expect that they would be active players, if you will, in the refresh cycle that we see in 2026. But Christian?

[Unknown Executive]

Yes. You were asking whether -- or how early customers would refresh. And many of the enterprise customers have enterprise agreements where they have account levels support and subscriptions. So they don't really wait until something expires. They will probably -- I would expect what we typically see refresh about ever before U.S. And for smaller customers, they will be try to wait until the contracts expire. But because we don't allow them to renew for less than a year, you also see the refresh cycles happening about -- yes, [ 15 to 18 ].

[Operator]

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

[Fatima Boolani, analyst]

Ken, a question for you. There was a discount about the routes to market in terms of gaining your market share within the SASE universe. And one of those important routes is leverage our installed base by converting and migrating a lot of the SD-WAN customers. So my question for you is how should we think about potential for the cannibalization of some of your refresh potential as that migration journey transpires from SD-WAN to SASE? And then I just have a follow-up for Keith, if I may.

[Ken Xie, executive]

Very great question. I think if you look at the customer, a lot of SASE is really supporting the DTA and also remote growth environment. So they are not kind of like any network security firewall deployment, which tend to be more in the office in the headquarter there. On the other side, it's most of -- if you look at our current SASE growing strong is most come from the current SD-WAN customer base or even the firewall customer base here. So that's where they do need a hardware firewall SD-WAN layer to support SASE with additional SASE user license with addition all these other functions service add-on there. So that's where we see like a 3 pillars, whether the secure networking side and also the SASE side, which will help add additional service and plus the other we call the secure operations side, all kind of starting growing. So we do believe we can keep in grow in all these 3 areas faster than the market, keeping gaining market share, especially SASE, the technology we can put out in the same OS with AC to accelerate and also supporting both the cloud SASE -- private SASE or Sovereign SASE is a huge advantage. And also comment, we also believe eventually, the service provider carrier will play some important role in SASE and offer a lot of their own kind of SASE to their customer. And so that's where we have very strong support in all the service providers build their own SASE infrastructure. And we do -- it's a huge growth potential on top of traditional network firewall market.

[Fatima Boolani, analyst]

And just Keith, for you to double back on the end of support analysts around the refresh that you're talking to and telegraphing for 2026. Any way you can give us a lens on either the proportion of the shipment footprint or the installed base footprint or the customer footprint that this applies to in the aggregate?

[Keith Jensen, executive]

Yes. At the risk of taking all the fun out of the Analyst Day in 10 days, I would say the second -- 2023 was -- 2022 was the second best second highest I looked at. '26 is a little bit more than 2x '23. So you're not coming to the Analyst Day.

[Operator]

Our next question comes from the line from Saket Kalia from Barclays.

[Saket Kalia, analyst]

Maybe for Keith or Christian, I think we mentioned as Solutions ARR growth number in the prepared remarks. Could you just remind us, is that an organic or inorganic number? And maybe just touch on what are the solutions that are driving that growth?

[Keith Jensen, executive]

Christian, do you want to...

[Unknown Executive]

Yes. So the growth number that Keith referenced was an organic growth number. We did not include the ARR that we acquired from Next DLP and Lacework. So the growth would be even higher year-over-year will be 150%. What are the solutions, the organic solutions that are driving this out, ARR growth is really FortiEDR, FortiClients, FortiNDR clouds, FortiWeb, so a variety of our cloud solutions and solutions that we've started to offer. Some of them are acquired, some of them are internally developed.

[Saket Kalia, analyst]

Got it. Keith, maybe for my follow-up for you. Just to shift gears a little bit, it was great to see the profitability again. Could you just remind us what -- you mentioned something about being onetime in nature in the quarter. It sounded small, but could you just remind us what that was? And more importantly, do you think about this as a more sustainable level of profitability?

[Keith Jensen, executive]

Yes. I think if I were to use the headline first, I would say the pro forma margins, if you back out that onetime benefit, product gross margin would have been about 68.4%, 68.5% and operating margin, if you backed out that benefit would be 35.1%. As you may recall, we have 2 different things that are impacting our margins in that regard. One is the traditional excess and obsolete inventory calculation related inventory you have on hand, that's pretty straightforward in comparison. The second one is Q2 deliverables. And the operations team has worked really hard with last year negotiating and renegotiating those. And we saw a benefit there that kind of pencils out to those margins I gave you in round numbers, we got a benefit there of about $15 million. That's very unusual. We've not seen that in the past.

[Saket Kalia, analyst]

And anything on sort of the sustainability of that margin? And if that risk pulling anything from the I totally understand. But I wanted to make sure the question was asked.

[Keith Jensen, executive]

Yes. I think we feel really good about the profitability of the business. And I think it comes back to where those investment vectors that Ken and John Will and others are going to really focus on as we go forward and how we want to invest there. But I think we certainly have ample room to invest in the growth of the company.

[Operator]

Our next question comes from the line of Tal Liani from Bank of America.

[Unknown Analyst]

You have Tomer Zilberman on for Tal Liani. Just wanted to ask about the billings guidance for next quarter. The organic billings ex Lacework and Next DLP came in well below Street expectations. Just wanted to ask where you see the weakness and how you measure that against the comments of seeing stable firewall demand this quarter and the expected refresh cycle in 2025?

[Keith Jensen, executive]

Yes. Great question. And I think what we're seeing when we look at the fourth quarter right now, we're really pleased with what we got out of the very first month of the first quarter. And I think that the second month is -- it's early yet, it's tracking. We're giving us pause or some chunky deals that are teeing up for the final month of the quarter. And they just need to mature a little bit before we start thinking about them as part of our guidance numbers. So I think it's really that population of large 7-figure and a few 8-figure deals that are kind of coming into play there a little bit.

[Unknown Analyst]

Got it. And maybe to follow up, asking more generally about the competitive landscape. We've seen over the last couple of quarters some of the larger vendors are now focusing even more on discounting, bundling and vendor financing. So how do you see the competitive landscape? Do you see pricing pressure because of that? And how are you participating with that as well?

[Keith Jensen, executive]

Yes. I think the -- maybe Christian will add a couple of comments here as well. But I think the discounting was very similar to what it's been in prior periods. As I mentioned, we certainly have ample margin to invest in a wide range of ways, and we're encouraging our sales team and our channel partners to take part of that. But I think there's also been some other changes in terms of incentives that we offer as well. But maybe Christian have som thoughts as well.

[Unknown Executive]

Yes. I think that overall, the discounting will expect to be pretty stable. But of course, it depends on the product set a little bit. And then yes, we have incentives in the market for channel partners, specifically but also for our customers to -- yes, to buy more Fortinet solutions.

[Operator]

Our next question comes from the line of Gabriela Borges from Goldman Sachs.

[Gabriela Borges, analyst]

Keith and Ken, I wanted to ask you about the go-to-market. And more specifically, I think it's been about a year since you upleveled your sales force around SSD. What are some of your learnings? What do you think is working well? And what do you think is incrementally a focus as we go into 2025 where you think you can maybe up level some more?

[Ken Xie, executive]

Yes. You can see the last 12 months, we made a huge progress in the SASE SSD go-to-market directly. But also, you can see Q3 some service provider also starting -- finally setting turn worth now and realize the importance of the SASE into their customer base. But it's probably still takes some time. But on the other side, we see our own customer base really like the SASE and very easy micro from the firewall in into -- so that's kind of probably 90% of our SASE business come from existing or security and also customer. And that actually helped us sell additional service, additional margin there. On the other side, the technology we have, whether the single OS, the ASIC sell all this function, it was advantage and to expand beyond traditional SASE market, which is only focused on a cloud-based society. So that's where we see the -- whether the sovereigns probably says even beyond go to the edge computing area with our kind of technology with appliance also CE especially for the OT/IoT area, both the hardware agents, software agent who's supporting all these OT device, we see also a huge growth potential there. So that's why we're pretty confident. So we're leading the SASE market and just like we did in the firewall SD-WAN space.

[Keith Jensen, executive]

Yes, I think, Ken spot on with that. I think that if you vary contrast where we are today versus a year ago, what I would say is that given the response that we get from customers when they meet with us, they're very excited about the architectural design of SASE that we've taken. And what we really want now is just more at that. When customers sit down with us and hear that story, it resonates with them, and you see that in some of the pipeline numbers and some of the ARR numbers that we're talking about, which are still very early days. And I think part of it is getting more reference customers involved. And I think also the channel needs to -- we need to partner more closely with the channel to make sure that we're getting more advanced on those sase opportunities.

[Ken Xie, executive]

Yes. SASE also the infrastructure were also different than other competitor. I think -- like I said, we own the 3 million square feet of our own kind of facility, which is our own data center can deliver the SASE function probably less than half compared to all the colon and then also kind of only 10% to 20% compared to some core provider, but we're definitely working with them because they have also good coverage. So that's where, for us, we do have a cost advantage on the infrastructure side, plus on the OS technology on Acceleration can lower the energy cost within the data center within all the SASE processing, I think we do have a huge advantage, both on technology, from infrastructure and also leverage the business customer base we have on the firewall SD-WAN. So that's the advantage we have over our other SASE competitors.

[Keith Bachman, analyst]

I think it's also interesting to note, like you said, we started really focusing on SASE a year ago, like Ken said, we've been building the solution for some time, of course. A year ago, at the November '23 earnings call right around that we broke out those 2 other pillars, Sassy and SecOps, externally and also internally to focus on those pillars. And you've seen really nice growth when we focus on solutions like that over the past year. It's only been a year -- and I think it's a little analogous when you think about kind of Fortinet's ability to execute. If you look at SD-WAN, which we started to really focus on in 2018, and then we've risen to be the leader in the Garden Magic Quadrant, it steadily grew over time. And so I think that those past results delivered around SD-WAN are illustrative of what can do when they focus on things. And we've really been focused on SASE and SecOps for that year. And so I think -- we had really good results over that -- over the course of that year in a very short period a lot more focus to come going forward.

[Operator]

Our next question comes from the line of Shaul Eyal from TD Cowen.

[Shaul Eyal, analyst]

Ken or Keith, in your press release, you're talking about Fortinet being well positioned to lead in its 3 core growth barriers and drive sustained growth. Keith, again, I don't want to spoil the Analyst Day front run it in advance, but sustained growth, what are we talking here? Low teens, mid-teens? Any color will be highly appreciated.

[Keith Jensen, executive]

Yes. I appreciate the opportunity to talk to it, but -- and maybe Ken walks to a little bit, although I would probably be careful what he says. I think we'll, obviously, we'll talk about 2025 as we get to the February earnings call, and we understand that the November Analyst Day is probably going to bake in some of the 2025 conversations. So I think that's -- it's a well-structured question, but I think we'll pause on answering it for now.

[Ken Xie, executive]

Yes, I agree. And so probably waiting for 10 days. And also you can in the investor slides, probably number 6, there's some information there. We'll probably provide more detailed information about total addressable market. how we want to grow faster than the market in each sector.

[Operator]

Our next question comes from the line of Rob Owens from Piper Sandlin.

[Robbie Owens, analyst]

Keith, I wanted to I guess, double back on your comments around Q4 and some of the chunky yielding up for the final month of the quarter, giving you a bit of caution. Was that not in your purview, I guess, when you were looking at the setup for the second half before? Have these things somewhat slipped relative to maturation, your ability to get them across the line. Just curious why the additional conservatism around them now?

[Keith Jensen, executive]

Yes. Great question. And I do think that compared to what we've seen in other quarters, maybe a little bit less or a little bit slower progress on the maturation of those larger deals in the third quarter as they got teed up for the fourth quarter. Certainly not shutting them out. I just -- I think it's more prudent right now to take a more cautious approach and let them mature a little bit.

[Ken Xie, executive]

It's another fact. It's really probably the first time we also started gave the RPO number and compared 1 year ago, some of the deal, probably Christiana can give more detail instead of finance from the channel, get a building right away for multiple deal, some of them may just using IPO just bill annually. Maybe Christian know this better.

[Unknown Executive]

Yes. As you can imagine, the customers won't pay years upfront. And so we have internal discussions around either getting the channel finance or do it ourselves, and this is also not mature enough be comfortable guiding in that direction, but gives us some pause because some customers just don't want to sign up for long periods without financing.

[Ken Xie, executive]

This maybe has a little bit short-term impact, but also benefit the company long term with better margin, better customer relation. So that's what we all looking for long-term success.

[Operator]

Our next question comes from the line of Catharine Trebnick from Rosenblatt.

[Catharine Trebnick, analyst]

Catharine Trebnick here. Can you discuss how your virtual firewall is performing this quarter or the trends for and competitively, we've been picking up that [indiscernible] have been doing a really good job with their virtual firewall. So how is that standing competitively with you?

[Keith Jensen, executive]

Yes. I think that the virtual firewalls have done very, very well. It is a component of Unified SASE as well as our network security portfolio. So -- and I think -- the other thing we look at is the crossover that we see, which is a very strong relationship between [indiscernible]

Are you still there, Catharine? Well, I'll just finish the topic. I think another thing we will talk about later this month is just the strong overlap that exists between our enterprise customers that are buying both physical appliances and virtual appliances.

[Operator]

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

[Adam Borg, analyst]

Great. Maybe for Ken, just on the Lacework FortiCNAPP offering now. I'd love to hear a little bit about initial customer feedback, partner feedback and kind of near-term R&D and sales and marketing priorities.

[John Whittle, executive]

Yes. I mean I think the feedback we're getting is similar to what we felt, this is John Whittle, by the way. What we found when we did our diligence, great product, great engineering team. It's an incremental TAM of $10 billion for us. So it really opens up that incremental TAM. Now we have out security, endpoint, network -- and we have great threat intelligence from all 3. So I think it's very, very positive feedback in terms of the quality of the product. We're continuing on the road map to improve the user interface in other areas and really make it a really, really, really strongly competitive product. I think it's very accreditive against some who have kind of pieced their solutions together based on multiple acquisitions forming their CNAPP solution. And so what we find is, in that context, oftentimes, we hear this feedback from customers a lot, they're not well together. It's reportedly integrated, but it's not Lacework CNAPP Solution was largely developed organically by them to all seamlessly work to us. We're hearing really positives on that front. And then also versus other competitors, we do have this broad suite of products that we can offer together versus other kind of single point, single product vendors who just offer snap. So we have real differentiators against the others in this space that we see working to our advantage.

[Ken Xie, executive]

Both company has a market-leading technology and the team there are also pretty strong. On the same time, also kind of bet as a company, so keeping hand-on solution -- integrated solution there, and that's probably better than other competitors actually let our customer base, leverage our also strong R&D resource, both combined solution and also send a lot solution to supporting customer units, a new $200 billion total addressable market, I think it's definitely a huge growth potential, both in the in secure app but also in the SASE space.

[Adam Borg, analyst]

That's great. And maybe just as a quick follow-up. Just on the government vertical. Obviously, 3Q is important for the U.S. Fed. I know the Fed is a little bit smaller of a vertical for Fortinet. But maybe talk about the government vertical more broadly in the quarter and how you think about it in coming periods?

[Keith Jensen, executive]

Yes. To your point, we're not really aligned with the U.S. part of the market for us, the government part is more state and local as well as international government. So you don't really get the same sort of 9/30 benefit that maybe some other companies see.

[Operator]

Our next question comes from Patrick Colville from Scotia.

[Unknown Analyst]

This is Joe Andrew on for Patrick Colville. Can you just talk more about how you're enabling or incentivizing partners to kind of lead with Fortinet SASE when they may already have existing relationships with more established vendors in this space?

[Ken Xie, executive]

Yes, you can see the Follet channel partner, you can see a lot of the actuality is our partner for network security and also SD-WAN to the very easy upgrade class to SASE. And a lot of also compared to whether the cost, the security, the performance, the flexibility at the broad range, we're also not better than any other competitor. So it's quite easy to migrate from some of our competitors to Fortinet, but we do see some kind of acceleration there. The other part is also we have a pretty big SMB customer base. SMB went up probably only single digit has any kind of network security deployment. We also see that's also one of the fast-growing areas because they do suffer a lot of runway out these contents. So we do see there's additional segment we can grow and at the same time for service provider for big enterprise to do this private solvency strategy, that's also one other competitor can offer whether in the same OS or the local data center deployment within the customer premise there. So that we feel we have quite some differentiation can give us huge advantage over other competitors.

[Operator]

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

[Joseph Gallo, analyst]

It was great to see the OT grew 19% billings growth. How should we think about sustainability of that business? And then are there any changes in that competitive landscape?

[Keith Jensen, executive]

Well, I think that very bullish on the OT market, but the leadership opportunity for us.

[Ken Xie, executive]

Yes. OT is the other year, we already did the space in some report, we're the only leader in OT security. We do believe also investing this year for a long time. And also, we believe in the next 5 to 10 years, probably most connection will come from is a device level and which most of them probably have a difficult way to deploy the agent software on the have to use network security. So we see a huge opportunity this OT combined resulted edge computing with view, it's will be the strongest growing area in the next 5 to 10 years. And so leverage, whether the OS or ASIC technology and also the infrastructure we have, we feel there is a huge opportunity there. We'll be driving or definitely to have the long-term amount of growth.

[Joseph Gallo, analyst]

And then maybe just to double-click on retail and some of the verticals. It was great to see that, that grew for the first time, I think, 6 quarters. Now that we're post election? Like are there any verticals that you expect to rebound? Or are there any changes going forward over the next couple of quarters that we should expect?

[Ken Xie, executive]

We see the manufacturer already pretty strong in Q3. We feel the postelection properties as we also begin accelerating there. Also, the other one like a carrier service provider is out of the market. We still finally see some growth after probably 6 quarters. And probably some other like retail, like it's pretty strong growth in 2001, 2002 -- 2021, 2022, almost by the 100% growth in some [indiscernible] So I think like that's probably will be most statin the refreshing cycle studying whether next year or '26, because we see the number of units in that space registered in a go through most like 4 years, we probably more reach to the time to refresh now.

[Operator]

Our next question comes from the line of Keith Bachman from BMO.

[Keith Bachman, analyst]

I wanted to ask two questions, sort of a micro and a macro and I'll just ask them concurrently in the interest of time. Keith, just on the SaaS penetration. You indicated on Slide 9, about 45% is with large enterprise. If you took out the SD -- and it's a very impressive figure. If you took out the SD-WAN. What would that penetration rate or share look like in terms of customer type? I'm just -- I'm trying to understand the SD-WAN versus the other bucket. And then the second question is a broader question, but how are you thinking about Europe as you look out over the next quarter or 2? I know it's T plus 1 in terms of the election and what economic growth may be as a consequence. But just how are you looking at Europe over the next couple of quarters, not just in Q4? And that's it for me.

[Keith Jensen, executive]

Yes, maybe we've confused you or I confuse myself on Slide 9. I don't think that's showing penetration, the mix of customers.

[Keith Bachman, analyst]

Yes. Yes. That's what -- sorry, that's what I meant, but what would the -- just a mix of customers, if you took out SD-WAN of the SASE piece alone?

[Keith Jensen, executive]

You're going to find a mix of customers that more tilted to the larger enterprises, if you look at SASE alone than when you look at the entire universe would be my expectation. I think we said. It has -- when you look at dollar values, right, not customer accounts.

Yes. Europe, I mean, Europe was -- I think we mentioned on the call, international EMEA was number one. I think U.S. was #2 in Europe is right behind them on #3. It's a little bit like the SMB headlines that we talk about every quarter that the economy is well every worries about SMB, and it continues to do well. I'm not saying there aren't pressures in Europe. And as we look forward to the fourth quarter, I don't know that we're expecting anything like an outsized performance from Europe, but we'll see how the quarter comes out.

[Operator]

Our next question comes from the line of Janice Quek from

[Janice Quek, analyst]

I just want to drill down in your hardware appliances. And if you can maybe just give us a little bit more color how the high-end family performed versus the midrange and the lower end?

[Keith Jensen, executive]

Good question. Looking for some numbers real quick here.

[Unknown Executive]

So overall, I would say, mid-range and high-end has continued to be stable, but not outgrow. We had a little bit more unit shipment in the end.

[Keith Jensen, executive]

I guess what we're saying is it's not going to jump off the page when we look at our numbers. How's that.

[Operator]

Our final question comes from Gray Powell with BTIG.

[Gray Powell, analyst]

So yes, it was really helpful to see the product level is growth rate disclosures on the slide deck. Within Universal Sassy, -- could you maybe give us a ballpark sense as to how fast the SD-WAN piece is growing? My understanding is that that's probably been under pressure over the last 18 months. So I guess my question is really like, do you see potential for that product to reaccelerate, particularly as VMware customers start looking for alternative solutions?

[Keith Jensen, executive]

Yes. I think we're -- if you look at our SD-WAN space, and we -- I think we made reference to the penetration in the larger enterprises that something on the order of 65% or 70%. That is of our customer base. Greg, as you're pointing out, the opportunity for us to see greater growth here is by -- in white space accounts and bringing them on board with the FortiGate and SD-WAN solution and starting them on that customer journey that goes FortiGate SD-WAN SASE. I think you're going to get some renewals from the early adopters of SD-WAN here as we start looking into 2025 and into 2026, that would be natural. I think that those same -- just as we're going through a renewal cycle for SD-WAN, our competitors will be also, and we've historically shown where we have a superior product like SD-WAN, that's an opportunity for us to just lodge the incumbents.

[Ken Xie, executive]

Yes, agree. If you look at the top 5 SD-WAN provider, we are the other one internally developed in with security and also the strategy of these things on the other comp acquisition, a lot of content also being sold after a core some of SD-WAN. So they're kind of a function of technology already stop developing in a few years now. And come up the refresh, we do see a huge opportunity. It's still very fragmented space, but we do see a lot of replacement opportunity deal right now. And we also feel we are not only leading technology, but also performance cost, energy consumption. So that's why we feel the SD-WAN, we're keeping accelerating and grow faster than the market, gaining market share there.

[Operator]

This does conclude the question-and-answer portion. I will now turn it back over to Aaron for closing remarks.

[Aaron Ovadia, executive]

Thank you. I'd like to thank everyone for joining today's call. As a reminder, we will be holding an Analyst Day on November 18, marking our 15-year IPO anniversary, where we will share the company's vision for the future of cybersecurity and provide an update on our strategy and midterm financial model. We will also be attending investor conferences hosted by Barclays, Needham, Scotiabank and Wells Fargo during the fourth quarter. The webcast link will be posted on the Events and Presentations section of Fortinet's Investor Relations website. If you have any follow-up questions, please feel free to contact me. Have a great rest of your day.

[Operator]

This concludes the conference call. Thank you for being here. You are now flying to disconnect.