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Fortinet Inc
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Ladies and gentlemen, thank you for standing by, and welcome to the Fortinet Fourth Quarter 2019 Earnings Announcement. At this time, all participants are in a listen-only mode. After the speaker’s presentation, there will be a question-and-answer session. [Operator Instructions] I would now like to hand the conference over to your speaker today, Peter Salkowski. Please go ahead sir.
Thank you, Sherri. Good afternoon, everyone. This is Peter Salkowski, Vice President of Investor Relations at Fortinet. I am pleased to welcome everyone to our call to discuss Fortinet’s financial results for the fourth quarter and full-year of 2019.
Speakers on today’s call are Ken Xie, Fortinet’s Founder, Chairman and CEO; and Keith Jensen, Chief Financial Officer. 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, providing our guidance for the first quarter and full-year of 2020, before opening the call for questions. During the Q&A session, we ask that you please keep your questions brief and limit yourself to one question and one follow-up question to allow others to participate.
Before we begin, I would like to remind everyone that on today’s call, we will be making Forward-Looking Statements and these forward-looking statements are subject to risks and uncertainties, which could cause actual results to differ materially from those projected. Please refer to our SEC filings in particular the risk factors in our most recent Form 10-K and Form 10-Q for more information. All forward-looking statements reflect our opinions only as of the date of this presentation, and we undertake no obligation and specifically disclaim any obligation to update forward-looking statements. Also all references to financial metrics that we make on today’s call are non-GAAP unless otherwise stated. Our GAAP results and GAAP to non-GAAP reconciliation is 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. Lastly, all references to growth are on a year-over-year basis unless noted otherwise.
I will now turn the call over to Ken.
Thanks, Peter, and thank you to everyone for joining today’s call to review our fourth quarter and full-year 2019 results. We are pleased with our very strong fourth quarter performance. Builders increased 24% to $802 million driven by solid execution and growth across each of our markets EMEA and APAC.
Revenue increased 21% to $640 million with product revenue up 19% and service revenue up 23%. Non-GAAP operating margin was 27%. For 2019 builders increased 21% to $2.6 billion. Revenue was up 20% to $2.2 billion and our non-GAAP operating margin was 25%. This strong result was driven by our advanced FortiGate technology with SPU and Secure SD-WAN, our integrated security fabric platform and hybrid multi-cloud offerings.
Fortinet was recently named one of the top three vendor in the 2019 Gartner Magic Quadrant for WAN Edge Infrastructure. FortiGate security driven networking approach to SD-WAN offer customers the most comprehensive solution with security enterprise-grade networking capability integrate in a single box. Our unique approach has allowed us to gain significant market share over the past 12 months.
With more than 21,000 companies using Fortinet’s Secure SD-WAN solution and 70% of our top-tier service provider offer our SD-WAN solution. We are now the leading SD-WAN vendors. Today, we announced the release of FortiGate 40F, the most affordable next-generation firewall with secure SD-WAN. The 40F include our new SoC4 security processor.
The 40F delivers security computer reaching of three to 23 times faster than industry average price, which use generic CPUs. The traditional parameter based network security has expanded across the entire infrastructure. To the wide area network including SD-WAN and 5G and put a local area network including the Wi-Fi and internal segmentation. Fortinet ability to offer security driven networking and high-performance with our SPU technology are clearly competitive advantages.
Going forward, we are working hard to ensure that Fortinet three growth engine will help us grow faster than our competition and the market overall. First, we continue to gain market share in network security driven by our SPU competitive advantage. Our SPU technology enable us to add cutting-edge security and network functionality including SD-WAN, while maintaining strong performance despite network traffic continued to increase.
The introduction of the new FortiSPU like SoC4 and NP7 as well as the first FortiGate product built with NP7 to be announced later this month is expected to widen our competitive advantage. The second growth engine is our security fabric platform included hybrid and multi-cloud deployment.
Unlike competitive platform that bring together loosely integrate acquired solutions Fortinet Security Fabric which from the beginning was most developed internally offer a broad automated and truly integrated security platform for end-to-end protection, making it easier for customer to consolidate a few security vendors.
Third, our engineer focused culture of continuous innovation strongly positioned Fortinet for long-term growth and competitive advantage. It is at least three times the technology pattern computer competition. Fortinet IoT, OT, 5G, hybrid cloud and edge solutions are leading the transition to the latest generation of cybersecurity. I want to thank the Fortinet team and our partners for their ongoing hard work and our customers for their support.
Now I will turn the call over to Keith for a closer look at our fourth quarter and full-year performance and to provide guidance for 2020.
Thank you, Ken. Let me first note that except for revenue. Financial amounts are non-GAAP and growth rates are based on comparisons to the fourth quarter and full-year of 2018 unless stated otherwise. The slide references I make refer to the presentation posted on our Investor Relations website.
I would now like to provide a summary of our strong fourth quarter performance and follow-up on certain metrics from the Analyst Day. We believe the metrics we shared last November highlight our diversity by geography, customer size, industry segments and solutions as well as provide insights into our financial model. Let’s start our fourth quarter review with revenue. Total revenue of $614 million was up 21%.
Revenue growth was led by the fabric and cloud segments with over 30% growth followed by network security growth at 18%. Product revenue growth was 19% or $239 million benefiting from both legacy firewall use cases and consistent with Ken’s SD-WAN commentary from continued adoption of our FortiGate-based secure SD-WAN solution. Simply put, our secure SD-WAN firewall use case combines in a single appliance security, with application-aware routing that can lower MPLS and other costs.
The fourth quarter revenue growth of 19% was consistent with our strong third quarter performance even when faced with a more difficult year-over-year comparison. We believe our product revenue growth may be among the highest in this network security industry. Moving to service revenue.
Our higher-margin service revenue increased 23% to $376 million and represented 61% of total revenue, increasing 10 points in four years. FortiGuard security subscription revenue increased 24% to $205 million. FortiCare Technical Support and other service revenue increased 21% to $170 million. Renewal rates remained consistent with prior periods and within the guidelines we provided at the Analyst Day.
Deferred revenue at the beginning of the fourth quarter accounted for approximately 90% of service revenue. Revenue growth on a geographic basis saw the Americas up 23%, APAC up 22%, and EMEA up 19%. Before continuing with our fourth quarter results, I would like to highlight our revenue performance for the year. Total revenue for the full-year grew 20% to $2.2 billion. Product revenue grew 17%. Service revenue grew 21% and represented 63% of total revenue.
Returning to the fourth quarter with a focus on billings. Total billings increased 24% to $802 million. Network security products and service billings increased 20% and accounted for 73% of total billings. Illustrating the continued traction with our Fabric platform and cloud strategies non-network security billings increased 35%.
In Europe, we saw Germany performed better than planned, while in the U.K. billings declined. The U.K. decline appears related to Brexit distractions and we expect U.K. billings growth will return to positive territory in the current quarter. Looking at billings by vertical, service providers and MSSPs accounted for 18% of total billings. And we experienced outpaced growth from government, financial services, retail and education.
As a follow-up to the Analyst Day, we are not the top five verticals again accounted for 65% of total billings. At year-end, total deferred revenue increased 27% to $2.1 billion and short-term deferred revenue increased 22% to $1.2 billion.
Looking now at deal sizes and illustrating our continued expansion in the enterprise market. Deals over $1 million increased 36% to 64 deals. Secure SD-WAN was a leading contributor to the increase in the number of deals in excess of $1 million accounting for 10 deals in the quarter up from four deals last year.
And with a reference to our diversification, we have now completed 11 quarters in a row without a single transaction representing over 2% of quarterly billings. The number of deals over $250,000 increased 29% to 469 and the number of deals over $500,000 increased 53% to 197. In the fourth quarter, our average contract term increased one month to 26 months.
As we noted at the Analyst Day, secure SD-WAN transactions included a greater mix of enterprise customers and somewhat longer contract terms. Moving back to the income statement. In the fourth quarter, gross margin improved 230 basis points to 78%. Product gross margin improved 400 basis points to 61.9%.
As we saw in the third quarter, product gross margin benefited from gains in average selling price as well as lower direct unit cost and indirect cost. We are pleased with the product gross margin improvement we have achieved in each of the last two quarters. Services gross margin increased 90 basis points to 88.2%.
Operating margin for the fourth quarter increased 110 basis points to 26.8%. The improvement in gross margin was partially offset by an increase in the pace of hiring mostly in sales and marketing, lower sales attrition and spending associated with recent M&A activity.
For the full-year, gross margin was 77.5%, up 150 basis points from 2018, benefiting from a 190 basis point improvement in product gross margin. And for the full-year, the operating margin was 24.5%, up 220 basis points from 2018. Total headcount ended the year at 7,082, an increase of 21% from the end of 2018. However, the two fourth quarter acquisitions increased headcount by 135.
Excluding these two acquisitions, headcount would have increased 19%. Given the strong operating income performance, net income for the fourth quarter was $132 million or $0.76 per diluted share. Net income for the full-year was $432 million, an increase of 35% resulting in earnings per diluted share of $2.47. On a GAAP basis, we reported full-year net income of $327 million or $1.87 per diluted share.
This represents our 11th consecutive year of GAAP profitability. Our milestones, we have been able to achieve every year since becoming a publicly traded company in 2009. Moving to the statement of cash flows summarized on slides 10, 11 and 12. Adjusted free cash flow for 2019 increased 28% to $776 million.
Capital expenditures for the fourth quarter were $47 million, including $36 million on real estate spending. For 2020, capital expenditures are expected to be between $210 million to $240 million, which includes spending on the campus expansion.
We expect first quarter total capital expenditures to between $25 million and $35 million, again including spending on the campus expansion. In the fourth quarter, we repurchased approximately 303,000 shares of our common stock for a total cost of $23 million. For the full-year, we repurchased 1.9 million shares for a total cost of $141 million.
At the end of the fourth quarter, the remaining share repurchase authorization was $1.6 billion with a plan set to expire at the end of February 2021. Before wrapping up with guidance, I would like to offer information on two additional areas: our fourth quarter acquisitions and also SD-WAN.
First on the M&A side, we completed two technology and talent tuck-in acquisitions in late October and December. With the combined contribution to fourth quarter revenue was significantly less than 1%, these acquisitions pulled down fourth quarter operating margin by approximately one-half of a percentage point.
We expect the impact from these acquisitions on first quarter and full-year 2020 operating margins to be roughly a 100 basis point headwind. Second, our secure SD-WAN offering continues to be a point of differentiation for Fortinet.
In the fourth quarter, Secure SD-WAN billings represented high single-digits of total billings. In 2019 for the full-year, Secure SD-WAN added about seven points to product revenue growth and represented mid to high single-digits of total billings.
On a full-year basis, there were no significant changes to the year-to-date third quarter metrics for Secure SD-WAN that we provided at the Analyst Day. Service contracts continue to attach to the FortiGate at a rate consistent with other FortiGate use cases. And finally, new logos continue to account for approximately 50% of secure SD-WAN billings.
Next I would like to review our outlook for the first quarter and full-year 2020 summarized on slide 13 which is subject to the disclaimers regarding forward-looking information that Peter provided at the beginning of the call.
For the first quarter, we expect billings in the range of $635 million to $655 million; revenue in the range of $555 million to $565 million; non-GAAP gross margin of 77.5% to 78.5%; non-GAAP operating margin of 19% to 20%; non-GAAP earnings per share of $0.50 to $0.52 which assumes a share count of between $175 million to $177 million.
We expect a non-GAAP tax rate of 24%. As I begin to provide 2020 guidance, I would like to remind everyone of the financial model expectations for the next three years that was provided at the November Analyst Day. For the period from 2020 through the end of 2022, we expect organic billings and revenue growth to be at least 15% for each of the next three years.
And non-GAAP operating margin to average at least 25% during this three-year period. For 2020, we expect billings in the range of $3,025,000,000 to $3,075,000,000. Revenue in the range of $2,525,000,000 to $2,555,000,000. Total service revenue in the range of $1,635,000,000 to $1,655,000,000.
Non-GAAP gross margin of 77.5% to 78.5%. Non-GAAP operating margin of 23.5% to 24.5%. While we estimate the recent acquisitions will be a 100 basis point year-to-year headwind to our 2020 operating margin included in the numbers above, we believe our operating margin over the next three years will average at least 25%.
Non-GAAP earnings per share of $2.70 to $2.73, which assumes a share count of between 180 million and 182 million. We expect our non-GAAP tax rate to be 24%. We expect cash taxes to be approximately $40 million. Along with Ken, I would like to welcome the CyberSponse. And again, the enSilo teams to Fortinet and thank our partners, our customers and the Fortinet team for all their support and hard work.
With that, I will hand the call back over to Peter.
Thank you very much Keith. Operator, we are ready to open up for Q&A please.
Thank you. [Operator Instructions] Our first question comes from the line of Brian Essex with Goldman Sachs. Your line is now open.
Hi. Good afternoon. Thank you for taking the question, and congratulations on some nice results. I was wondering Keith maybe you could unpack the guidance a little bit. Coming in particularly on the growth side of the equation several hundred basis points over your kind of at least 50% - 15% guide on the Analyst Day. What is the confidence there come from? And what are some of the levers that could, I guess, give us some comfort that there is your appropriate level of conservatism in that number?
Yes, I think the - when you look at our longer-term model you are probably looking more at Gartner growth rates in terms of what you expect to see from SD-WAN what you expect to see the network firewall. And what you see - and what you expect to see in the Fabric. And I think the guidance is certainly within those ranges when you factor in our historical ability to outgrow the market. I think as you get - if you pull that in particularly to say the first quarter or even the current year, it is much more based upon the pipeline. And when we look at the pipeline and the opportunities that we see in the pipeline it clearly supports the guidance that we have just provided.
Also we do increase the sales capacity with the additional hiring and sales and marketing reaching close to 20% total headcount increase will definitely help to drive that additional growth.
Got it. That is helpful. And maybe if I could follow-up with a quick one on the current results for the quarter. Product revenue nicely strong in the high teens in services revenue as well during a quarter where maybe some of your peers sound a little more challenging to put up positive product revenue growth at the very least. How much did I guess SD-WAN and Fabric contribute to each of those segments? And how might you view the overall spending environment for core firewall considering the results that you had? And I did hear you comment on high single-digit SD-WAN contribution, but if maybe you could paint a bigger picture of other contributing factors to those line items? And the spending environment overall would be really helpful?
Yes, this is Ken. For the network security, we believe we are keenly gaining a lot of market share, because the product architecture with our own ASIC how we call SPU is has huge concrete and power and keeping adding whether security function or the networking function of SD-WAN. Even the product we announced today like that is from 3x to 23x more powerful than other competitor industry average. So this will make us keeping gaining market share. And also SD-WAN market last year is about 1.5 billion and they grow 15% year-over-year in the next few years. So we are not a leading vendor SD-WAN with the most customers and also service provider also starting adopt our SD-WAN solution. So we do believe we are also keeping gaining share in that space. So that also will help us. And that the Fabric, you can see almost double the network security growth because our Fabric is mostly internal develop and well integrated. That is more easy to like upsell, cross-sell once some product adding in and because of the other part of Fabric kind of working together quite well. So that is where customers see the benefit of consolidation. So we see that is also a growth driver. There is a few other new technology. We also pioneered and - but that is probably more long-term maybe still a few more years to see more materialized but we do - we also lead in some of the technology change in unit space.
Thank you. Our next question comes from the line of Brad Zelnick with Credit Suisse. Your line is now open.
Fantastic. And I will echo my congratulations. What a real strong finish to 2019 and impressive guidance as well. Ken, if I can ask you a question. As I look to competing SD-WAN solutions out in the market, I think there are some out there that take a different architectural approach in delivering it mainly as a cloud service. Aside from customer preference, can you maybe speak to the architectural trade-off of centering the functionality in the cloud versus delivering it as you do?
I think by moving some applications to the cloud actually helping like multi-deployment in SD-WAN. And at the same time even within the cloud there is a few research actually weather from the government and I say all come from like academia like CMU is that the cloud actually increased the security risk. And that is where even within the cloud you also need to secure the cloud itself. So that is also helping like we call hyperscale some other kind of approach to get inside the network. And so that is probably beyond the traditional - I mean the one SD-WAN side. So that is where we kind of working with a lot of service provider, cloud provider and make SD-WAN part of the total offering. And then we also understand sometime they have their own business model. We most supporting each other instead of more competing on each other. So that is kind of the ecosystem study working quite well for us.
Thank you. That is very helpful, Ken. And Keith, if I could just follow-up with a quick one for you. DSOs seem to be running a little bit hot. Can you comment at all on linearity. I mean at the same time you have obviously guided to a very nice Q1 and full-year next year. But any color on the jump would be helpful? Thank you.
Yes, I think the math of DSO. We picked up about a day from the acquisitions. That pretty much puts us back in line with what you would expect normally. I would offer my experience in high-tech and the Christmas holiday season is always very busy. I still think Fortinet’s unusual.
Thank you. Our next question comes from the line of Melissa Franchi with Morgan Stanley. Your line is now open.
Thank you for taking my questions and congrats on a solid quarter. Ken, it looks like you are seeing good growth in large deals and multimillion dollar deals. And I know that you said that SD-WAN is a leading contributor to strength there. But I’m just wondering if you could provide more color on what those deals look like? Is it your existing customers that are refreshing at the branch, or are you displacing some competitor solutions that are coming and you are coming in because of the SD-WAN capability?
So half the SD-WAN customer are new customer, especially come from large enterprise. That also enable us to get into the traditional enterprise network security space or even the internal occupancy. The traditional parameter based network security now need to be expanded to the WAN side like SD-WAN 5G and also to internal like whether the internal segmentation switching the internal Wi-Fi. So that is where we see that probably internal even bigger market compared to the SD-WAN side. And so we see a huge opportunity especially we introduced the new NP7 so the first product leverage NP7 which is about five times faster than the previous chip NP6 will help us get inside a network in a very high-speed environment within the cloud. So that is also what drives additional growth. So I do see - so SD- WAN go to the one side and also go to internal network side, help us expand a lot of our new market inside enterprise and also in a lot of new customers for us.
Okay very helpful. And then I have a follow-up for Keith. Keith you mentioned that ASPs were increasing in your commentary on gross margins. Can you just maybe comment on what is driving that ASP increase? Is that just a mix shift dynamic? Or did you actually raise prices on appliances?
Yes, I think what I’m trying to do is parse out the fact that in the benefit to gross margin there was really three pieces to it. Indirect, which I would attribute to economies of scale that we are seeing. We have a large warehouse facility that we acquired a number of years ago that and I think that is a fairly permanent benefit on the indirect side.
On the direct side, I think the operations team does a very good job of each quarter working down the average direct unit cost. And then the third component was ASP. And I kind of broaden that conversation if you will a talking point.
The last quarter I attributed to discounting. And the reason for that is, I would put discounting as a component of ASP, but I also want to give some credit to the ability to the company if you will to maintain a somewhat normal price list changes you have from time-to-time and not giving up those back - giving those back in discounting.
Other economist scale working is really the ASIC chip, right? So we are the number one unit shipment probably more than the number two, number three, number four combine as well it help us really kind of a lower average cost of per ASIC chip, which gives us huge computing power over the generic CPU, the competitor using. So that is also helping driving the cost lower?
Very helpful. Thank you.
Thank you. Our next question comes from the line of Shaul Eyal with Oppenheimer. Your line is now open.
Thank you. Good afternoon gentlemen. Congrats on a strong performance. Keith or Ken, Germany and the U.K. or maybe we should call it Frankfurt and London, tale of the two countries, tale of two cities. Talk to us a little bit about what has been driving the strength in Germany? And why do you expect the U.K. to bounce back in the first quarter?
Yes. sorry, Ken, I didn’t mean to jump on you. I think in Germany, I think it has been a balanced growth throughout the quarter. I think we came into the quarter with perhaps some concerns given the economy there in Germany. But the diversification that we see within the country I think paid off for us. I think in the U.K. to answer the question very specifically, when I look at the pipeline in Q1 versus what we saw in Q4, I feel very comfortable to comment about it returning to positive growth in the quarter.
Fair enough. Fair enough. And maybe a lot of the same lines that, I pass at APAC? What is driving that? And do you see that contribution or growth as sustainable within that region?
Yes. APAC has a pretty good fourth quarter. And also we starting to speed up some hiring there, which is a little bit behind early last year, which also can helping drive the future growth.
Thank you. Our next question comes from the line of Fatima Boolani with UBS. Your line is now open.
Good afternoon and thank you for taking the questions. Ken, I will start with you. Just with regards to SD-WAN tremendous momentum there. I wanted to understand just from a strategy perspective, how you are pitching the SD-WAN value proposition to your telco and service provider and carrier partners, because to some extent the secure SD-WAN proposition is counter to the other areas of telco’s businesses like the MPLS stream. So I wanted to better understand what your strategy is with telcos? And then I have a follow-up for Keith if I may.
Yes, it is a lower total cost of ownership, especially we have a one box solution compared to some other order network vendor whatever they didn’t have a two, three box one for SD-WAN and one for security, one for networking.
So we have all this integrated single box. And also because the huge computing power come from our SPU security process unit, so we can easily outperform and add additional function combined all the security network function together. And still like easily like three to 30 times faster than other like a single SD-WAN function part of security box.
So that is the advantage we have in the technology investment for ASIC chip give us huge computing power, not just for the SD-WAN function, but also additional security function, additional network function if we keeping adding there. So that is where the service provider enterprise see huge benefit because for them they can whether using the box to - service-based revenue of kind of helping lower enterprise total cost.
So that is where we see over 70% top-tier service provider offer our SD-WAN solution. So that is where we become a leading vendor. We believe we have the most customer base starting to adopt our SD-WAN 21 selling customer companies starting using our SD-WAN which combined SD-WAN security together.
And also it is very interesting. So the service we offer with SD-WAN enter the highest level service we have. So we do have like a UTM service. We have enterprise service and then that we call 360 service which like including all the UTM enterprise and class all the provisional services including SD-WAN provisioning and management service.
So SD-WAN definitely helping drive the additional service, additional security into a lot of new enterprise customer, half the SD-WAN deal has come from a new customer which never bought our product before.
Yes. And I think just a follow-up on Ken’s comment about the 30% of the SD-WAN service providers. I think we probably saw particularly in the first half of 2019 was a little bit of hesitation from the carrier and the service providers and maybe at a little to the MPLS revenue stream. But we have certainly seen a shift in that thinking I would say over the last three or four months.
That is super helpful. And Keith just for you. You are very specific about the step-up in sales hiring and sort of the higher pace of sales hiring. I’m wondering if you can put a finer point on where these additional sales resources and increased sales capacity is going to be concentrated whether from the vertical or geographical or even use case perspective. I would appreciate that color. Thank you.
Yes. I think the way I would probably respond to that question is the way we look at it in terms of adding sales capacity. And there is probably two key criteria that Ken and I talked about. One is we want to see somebody a sales leader whose demonstrated performance.
So when you give them more resources that they are going to be able to execute with it. And two, that they want that additional responsibility. Now luckily we are in a very good position where that crosses geographic lines and across these verticals. But I think that is more of the playbook that we are after right now.
Thank you. Our next question comes from the line of Sterling Auty with JPMorgan. Your line is now open.
Yes. Thanks. Hi, guys. Ken I wanted to start out with as we think about the SD-WAN product road map especially here in 2020, what are some of the key elements that you would expect to introduce this year that have been missing in the solution thus far?
We definitely more working closely with the service provider which we kind of are more dominant in the space and offer a lot of managed SD-WAN service and also a lot of our channel partners having more working with us is producing leaders, big city and big global city leader, so they see the benefit of SD-WAN solution compared to their traditional solution.
The other thing, we probably maybe with a little bit ahead right now is really the NP7, we kind of talked about in Analyst Day. And then later this month we introduced the first product beautiful NP7 accelerate in Barcelona which also will change the landscape. This is more like a product starting to go inside the network.
So that is where the internal segmentation, the hyperscale some other part of - or could be even bigger market than the wide air network, which is SD-WAN we will lead in the last few years. So that is where there is a few drivers worth keeping helping us, like I still see for more help us more in the SD-WAN in the one side is that integrates seasonal on chip.
And then NP7, we are helping on the local air network in a high-speed environment. So that is where we are starting to see the traditional parameter-based network security need to expand into the WAN side and also the LAN side.
Got it. And then Keith I apologize I was bouncing between calls, but I apologize if you covered it, but I want to better understand the operating margin guidance here for 2020. And in particular how much of that impact is coming from the enSilo acquisition versus the increased hiring? And specifically are you at the end of this maybe increased investment phase? And how does that margin outlook for 2020 fit within your longer-term margin guide?
Yes, I think very good questions. We tried to cover off in the prepared remarks that a reminder including the fact that our comment before was that from 2020 through 2022, we expect to average at least 25% operating margin during that three-year period of time. And that first and foremost that has not changed.
The other data point to keep in mind in the commentary was that the M&As that kind of hit in the tail half of the fourth quarter, the drag in operating margin in the fourth quarter was about 0.5 basis point.
And the drag for the next year when we have full quarter operations, it is going to be about one point of drag. And so one way of looking at it is taking our operating margin at the midpoint and then adding that point back into it.
Thank you. Our next question comes from the line of Walter Pritchard with Citi. Your line is now open.
Thanks. Question on the subscription side and specifically pretty good performance on the FortiGuard there. Can you help us understand components of that as you have seen that business accelerate this year. What is been the driver of that trend?
Yes. Fortiguard kind of go back to some commentary from the Analyst Day FortiGuard is about 85% of FortiGuard are bundles, security bundles. You can add to that some stand-alone security services if you will.
You are also going to get - when you are trying to model it, you can also get a lag effect of when you see high product sales say higher in 2018 than they were in 2017. Those higher product sales in 2018 are going to attach service contract, which become revenue in 2019. So you are going to get the lift in 2019 from the increase in product sales in 2018.
Got it. Then just a quick one on acquired revenue how should we think about any contribution from - you said a small contribution in Q4, any contribution from the two acquisitions in the 2020 number?
Yes, we have just rolled it in into the total. And I think the comment I gave was it was far less than 1% in the fourth quarter. I don’t really see that changing for the balance of that I have visibility to in 2020?
Okay. Thank you.
Thank you. Our next question comes from the line of Jonathan Ho with William Blair. Your line is now open.
Congratulations on the strong quarter. Just one for me. I just wanted to get your sense of what is happening in the cloud opportunity? You guys mentioned hybrid cloud and sort of the multi-cloud security opportunity. I just wanted to get a sense for what trends you are seeing particularly for 2020? Thank you.
Yes, we do see cloud as a part of our February offering. So we gave the customer flexibility whether they want to put on premise or go to cloud or chosen different cloud provider which we offered the same thing like a user interface the same software kind of a solution for them.
And also we are working with a cloud provider service provider well and try to expand in that area. So that is one of the growth driver for us. We do believe both cloud and edge need to be working together, certain things good for cloud, certain things good for the edge.
So that is where have the whole solution instead of only focus on one solution. So that is where we like what are the fabric on the cloud, the edge and other I mentioned like IoT, OT and the 5G or to be kind of working together to make it more secure.
Thank you. Our next question comes from the line of Michael Turits with Raymond James. Your line is now open.
Hey, guys. Good afternoon, good evening, great quarter. Firstly for Ken, you announced the Fortinet secure SD-WAN on Equinix. So SD-WAN you said as a full-service. What are your offerings? And what is your strategy on a full cloud-based security offering that you would think of that would be analogous to this Scalar offering either for local breakout and/or for Zero-Trust network access?
I think the Scalar don’t have the SD-WAN. And sometimes we also partnered together. And on the other side like a lot of service provider like Equinix or some other, they do have quite a broad customer base enterprise customer service provider and leverage their infrastructure.
So SD-WAN definitely is a new technology solution can - like improving the service, lower the cost and that is where both the service provider and the enterprise customer all like that solution. So that is where we kind of approach from both one from end customer angle and with our own marketing force with BDR resource and the other one comes from the service provider partner with them to help in their customer to improving that lower total cost ownership. So that is where we see working with service providers one of the very important ecosystem for us.
And then for Keith on cash flow, this year your cash flow grew less than net income this year 20s versus in the 30s? How should we think about it going into next year? Is that just timing that reverses? Should we think about cash flow from ops growing in line with net income or EBIT next year?
So if you are looking at the cash flow from operations then you are excluding the real estate, correct? You are not talking about free cash flow, Michael?
Not talking about free cash flow, just cash flow.
Yes. There is nothing different in terms of modeling it other than just maybe when the quarter ended, how payables got paid. And obviously we will get collected. And so your premise that basically to put words in your mouth, don’t look at the one quarter, but look at it over time, you are right.
Right. So in other words in line with net income or EBIT growth last year is a good guide?
Thank you. Our next question comes from the line of Rob Owens with Piper Sandler. Your line is now open.
Great. And thanks for taking my question. Wanted to drill down a little bit into linearity with regard to 2020. And I know in 2019 we saw very strong back half out of you guys and obviously some of the new products in SD-WAN helped there. But you are also making that push up relative to enterprise. So are we seeing the business become a little bit more enterprise back-end weighted? Does that play out in 2020? And what should our initial linearity thoughts be? Thanks.
Yes. Good question. We spent some time with that actually recently looking at it. And I think if you start looking at 2018’s linearity by quarter that is probably a pretty good idea of what we think - 2019’s linearity. We have got a pretty good idea of what 2020 will look like at least in terms of how we are modeling internally.
So you are probably looking book ending the year with starting off at say at 21% and ending the year in the fourth quarter with maybe 29%, 30% kind of a model. And in between where our model where Q2 and Q3 tend to be very close together. So you are probably around the 24%, 25% number for both of those.
Yes. We also improved hiring in the second half of 2019, which we hope will be contributing to the 2020 growth. So that is where the sort of hiring in like a Q3, Q4 definitely we will see some sales starting ramp up to contribute in this year 2020.
Great. And then if we look at the large deal metrics particularly the largest of deals, are these you guys pushing up market into data center situations that are massive or more branch network types of situations? Could you unpack that a little bit for me? Thanks.
It is more enterprise. That is because a lot of the enterprise see the benefit of whether SD-WAN or we call the infrastructure security involved in more product in Fabric. The Fabric also helping make the deal larger. So that is where with most sales, more partner able to sell multiple products and also the SD-WAN starting at more like a big enterprise. So that definitely helped increase the deal size.
Our next question comes from the line of Andrew Nowinski with D.A. Davidson. Your line is now open.
Great. Thank you. Congrats on a great quarter. So I also want to ask a question on your large deal growth, we saw deals greater than $500,000 and those greater than $1 million with impressive growth again this quarter, yet your high-end appliance revenue lagged the small and midrange appliance growth. So I was just wondering if you could just provide any more color as to why are customers spending more upfront with these and so it doesn’t look like they are buying - simply just buying larger appliances?
The new product coming like I said, it takes us almost four, five years we developed NP7. So that is where we finally released and the first part will come in later this month. So that we will have a huge advantage compared to some other product. So that will help.
Yes. Andrew, this is Keith. A good follow-up question to Rob and to expand on Ken’s comment. I think when you look at where the large deals are coming from I would probably say there is really three sources for those. One is the SD-WAN that we talked about. Two is the large distributed enterprise that you are referring to. And then the third is yes, having success inside the data center and displacing incumbents. And I think each of those are contributing to the growth that we are seeing in million dollar deals.
Great. Thank you. And then just a clarification regarding your gross margin. I know you mentioned the economies of scale as contributing to that, but the guidance for 2020 is a significant expansion from 2019. And I thought that new appliances typically carry a lower gross margin at least initially. And so given the new appliances you have talked about that are coming out later this month. I was wondering if you could provide any more color as to what might be driving your gross margin higher in 2020 and offsetting that perhaps initial headwinds you normally face with the new appliance?
Yes. Keep in mind we probably have 70 or 80 different firewalls on the price list at any one model at any one point in time. And then also add to that that when introducing a new product doesn’t necessarily mean it is going to have a significant revenue impact to a given point or to a given quarter. I think I won’t overplay the new products having an impact on gross margin, unless we are doing a lot of them all at once and they are coming online.
I think if you go back to what is actually to the extent you are talking about product gross margin and I think you were in your commentary, I made reference to three components. One is I think the indirect benefit is here to stay given the economies of scale. I do believe that the direct benefit Ken made reference to it with the ASIC advantage will continue to manifest itself into our pricing and into our billings.
And then thirdly, I now have two quarters in a row whether you want to call it ASP increases or holding line or discounting. I’m not going to commit to say that that is going to be forever. But I think those are the components that we are looking at in terms of our modeling of gross product gross margin going forward.
Lastly, if you are looking at total gross margin, it is really a mix shift as well where at the moment we are probably modeling a little more services with higher margin than we are with products at this point in time.
Yes. Also with the two new SPU whether this is SoC4 which is working for other NP7, we have a huge computing power enhancement on the FortiGate which also enable us to keep adding a lot of new function which can also drive the service helping like a less discount and see additional huge value added with the same cost. So that also will help to improve our margin.
Thank you. Our next question comes from the line of Dan Ives with Wedbush Securities. Your line is now open.
Yes. Thanks. So my question specifically on the government vertical. I mean, could you just maybe talk about what is going on there. Obviously, there is a lot of lot transformation going on in deals across especially on the federal side where you guys obviously play well. So maybe just talk about that in terms of the composition of deals activity and just is anything changing on federal?
Yes. Yes. I’m reading my email. I saw something this morning from one of our sales people talking about. Very exciting times are coming in the U.S. Fed. But I think really what you are seeing in our model right now is really the diversity in our federal business, pardon me in our government business, which includes some benefit from the U.S. Fed, but also state local and international governments.
Got it. And Ken could you just hit on 5G. I mean, I know you have talked about it before, but just how you are viewing that over the next 12 months to 18 months? And where Fortinet plays in that opportunity? Thanks.
In which one?
5G
5G.
Oh, 5G. I think it is still a little bit early. A certain vertical may be ahead of the consumer, we are working closely with a service provider, but I see is probably still need a couple of years out to see material impact.
Thank you. Our next question comes from the line of Patrick Colville with Arete Research. Your line is now open.
Thank you for taking my question, and congrats on seriously impressive quarter and next year’s outlook. Can I ask a financial question on the free cash flow to start with? How much are you spending in 2020 for the new campus?
Yes. The real estate spending will probably run between $150 million and $160 million all in next year.
Got it. Okay, very clear. And then Ken can I ask you about ransomware. I do a lot of work speaking to CISOs and CIOs. And in my conversations that is probably the number one threat their facing right now. So I would love to understand from Fortinet’s perspective, how at all that may be driving conversations with you guys and your customers?
Yes, that is a very important topic, because the majority attack today now comes from inside. So that is where internal security, internal segmentation and at the same time combined with some other like endpoint security, like the company we just acquired enSilo, and also it is really so I think they are more and more important.
And then also the new NP7 definitely help driving that direction inside our company network and whether segment different department or server or data source there and even per person. So that will help embed for this ransomware attack.
Thank you. Our next question comes from the line of Taz Koujalgi with Guggenheim. Your line is now open.
Had a question on the [Equinix] partnership. Can you just talk a bit about the go-to-market there? Will that be sold by Equinix or will that be sold by Fortinet? And how does the rev-rec -- how will the rev-rec work in that case? Would it be still a product or will that be recognized as a service offering?
Probably most starting from go-to-market together. And then we are also working on some other more deeper partnership including certain products - sort of other service offering, but it is a market starting off a good partnership.
Yes. And I think it is probably just a little bit early to talk about rev rec. The press release is that, it is in the last 24 hours.
Got it. And then, just a clarification on the guide. So given that your product revenues were basically - they grew at the same rate in 2018 and 2019. Would it be fair to assume that the service revenues, there is no decline in the service revenue growth in 2020? You should basically have the same service revenue growth in 2020 that you had in 2019?
Yes. I think we actually included in the guidance service revenue for the year. So I think that will probably give you a pretty good visibility to it, in the prepared comments.
Thank you. Our next question comes from the line of Chaim Seigel from Elazar Advisers. Your line is now open.
Hi, guys. Congratulations on a great quarter. I noticed, obviously that obviously the billings number was much higher than you thought. And I’m just wondering, what was the components behind that?
I think we saw a very good performance. Many, many Geos, I would count the U.S. as being a very, very strong Geo. We also did very well in our emerging markets in the quarter. It was strong, I gave you the revenue number, which is a pretty good indicator. But I think really, if I were to call out in terms of where the strength was in the quarter. I was very pleased with the U.S. in our emerging markets.
Congratulations.
And I should - pardon me, I got to mention on the TAM also we did a great job again. I’m going to get in trouble and they did a very good job.
Thank you. Our next question comes from the line of Nick Yako with Cowen. Your line is now open.
Great. Thanks for taking my questions. I wanted to ask about fabric. I’m just wondering, if you can provide any color around the percent of FortiGate customers that have deployed a fabric product? And then maybe how that is trended over the past few years?
I think there is if I’m understanding the question correctly, I think there is a very high correlation between fabric customers and FortiGate products. It is fairly unusual for us to sell a fabric product to somebody who is not a FortiGate product customer.
Right. Okay. And can you helpful color around the SD-WAN contribution in 2019? Any color on what that contribution was in 2018?
Very, very small. low single digits at best probably.
Okay. Great. Thank you.
Thank you. This concludes today’s question-and-answer session. I would now like to turn the call back to Peter Salkowski for closing remarks.
Thank you, Sarah. I would like to thank everyone for joining the call today, and let you know that Fortinet will be attending the following Investor Conferences in San Francisco during the first quarter. We will be at the Goldman Sachs Conference next week on February 11, and we will be at the Morgan Stanley Conference also in San Francisco on March 3.
Presentations for both of these events will be webcast and links to these webcasts will be available in the Investor Relations website for Fortinet. If you have any follow-up questions, please feel free to contact me. Have a great rest of your day. Thank you.
Ladies and gentlemen, this concludes today’s conference call. Thank you for participating. You may now disconnect.