Fortinet - Q1 2023
May 4, 2023
Transcript
Operator (participant)
Good day. Thank you for standing by. Welcome to the Fortinet's first quarter 2023 earnings announcement conference call. At this time, all participants are in a listen-only mode. After the speaker's presentation, there will be a question-and-answer session. To ask a question during the session, you will need to press star one one on your telephone. You will hear an automated message advising your hand is raised. To withdraw your question, press star one one again. Please be advised that today's conference is being recorded. I would now like to hand the conference over to Peter Salkowski. Go ahead.
Peter Salkowski (SVP of Finance and Investor Relations)
Thank you, Chris. Good afternoon, everyone. This is Peter Salkowski, Senior Vice President of Finance and Investor Relations at Fortinet. I'm pleased to welcome everyone to our call to discuss Fortinet's financial results for the first quarter of 2023. Speakers on today's call are Ken Xie, Fortinet's Founder, Chairman, and CEO, and Keith Jensen, our Chief Financial Officer. This is a live call that will be available for replay via webcast on our investor relations website. Ken will begin the call today providing a high-level perspective on our business. Keith will then review our financial and operating results for the first quarter of 2023 before providing guidance for the second quarter of 2023 and updating the full year. We'll then open the call for questions.
During the Q&A session, we do ask that you please limit yourself to one question and one follow-up question to allow others to participate. Before we begin, I'd like to remind everyone that on today's call, we will be making forward-looking statements. 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. We undertake no obligation and specifically disclaim any obligation to update forward-looking statements. Also, all references to financial metrics that we make today are non-GAAP unless stated otherwise.
Our GAAP results and GAAP to non-GAAP reconciliations are located in the earnings press release and in the presentation that accompanies today's remarks, both of which are posted on the investor relations website. Ken and Keith's prepared remarks for today's earnings call will be posted on the quarterly earnings section of our investor relations website immediately following today's call. Lastly, all references to growth are on a YoY basis unless noted otherwise. I'll now turn the call over to Ken.
Ken Xie (Founder, Chairman, and CEO)
Thanks, Peter, and thank you to everyone for joining today's call to review our outstanding first quarter 2023 result. For the first quarter, revenue growth was 32% due to strong growth in both product and service revenue. With 35% product revenue growth, we continued to gain market share while being a leading product revenue company in the cybersecurity industry. This strong product revenue growth will help drive future service revenue growth. Quarterly service revenue grow over 30% for the first time in six years. We believe we have a significant opportunity to upsell value-added secure service to our large installed base. In the first quarter, SD-WAN and OT bookings together continued to account for over 25% of total bookings, and our goal is to become the number one in network firewall, secure SD-WAN, and OT security market over the next couple of years.
Fortinet is leading the trend of network and security convergence and cybersecurity consolidation. Gartner expects that by the year 2030, the secure networking market will be larger than traditional networking. Traditional networking lacks awareness and control of content, applications, users, device, and the location, and is still using the same network protocol that was developed 50 years ago. Fortinet's secure networking solution has expanded from next-generation firewall to SD-WAN, SD-Branch, 5G, internal segmentation, SDNA, and Universal SASE. We believe the secure networking market can achieve double-digit growth annually for the foreseeable future. In today's environment, organizations are looking to consolidate their multiple security vendors and functions that are deployed across their expanding attack surface to lower their total cost of ownership and management cost while improving visibility and automating real-time threat detection and response.
Fortinet's latest release of FortiOS 7.4, together with the FortiSP5 ASIC, leads the industry in better integration and automation, as well as a faster acceleration while lower total cost ownership. FortiOS enable organizations to deploy the Fortinet Security Fabric to every edge, allowing security to dynamically scale and adapt as network evolves. Last month, we announced Universal SASE, which supporting hybrid infrastructure and enable the same networking and security features that are available in our plans to be delivered as a service, all within a single console. Many of our service provider partners are collaborating with us on these offerings. Also, we announced enhancement to several of our Fortinet Security Fabric solutions, including endpoint security, cloud security, SOC, and SOAR.
As networking and security continue to converge and customers looking to consolidate vendors and point product, we believe we are well positioned to achieve our 2025 billings target of $10 billion while generating an annual non-GAAP operating margin of at least 25% for each of the next three years. Before turning the call over to Keith, I would like to thank our employees, customers, partners, suppliers worldwide for their continuous support and hard work.
Keith Jensen (CFO)
Thank you, Ken. Good afternoon, everyone. Let's start with the key highlights from our strong first quarter performance. Our strong first quarter results reflect a continued demand for our broad portfolio of cybersecurity and networking solutions, and the demand for consolidation and convergence that is delivered by our integrated single-platform strategy. Total revenue growth of 32% was led by strong product revenue growth and service revenue growth accelerating to over 30%. Billings increased 30%, our eighth consecutive quarter of at least 30% billings growth. Secure SD-WAN and OT bookings once again accounted for over 25% of total bookings. Our strong top-line results reflect continued customer demand across both core and enhanced platform technologies and highlights the diversification of our business model by solutions, geographies, customer segments, and industry verticals.
We continue to deliver balanced growth and profitability with better than industry average top-line growth and strong profitability despite the continued economic uncertainty. The first quarter operating margin of 26.5% represents the highest first-quarter operating margin in our 14-year history as a publicly traded company. Free cash flow of $647 million, representing a margin of 51%, is up 23 percentage points. Both the quarterly free cash flow and free cash flow margin are Fortinet post-IPO records. Last month, we hosted nearly 3,000 customers and partners at our very successful Accelerate conference. I'd like to recap three key themes. One, the expanding firewall deployments environment. Two, convergence. Three, consolidation. Starting first, today's rapidly evolving threat landscape and connectivity demands a comprehensive approach to firewalls and network security, including a combination of hardware, virtualized software, and security services.
In fact, Gartner anticipates that by 2026, more than 60% of organizations will have more than one type of firewall deployment, which will prompt adoption of hybrid mesh firewalls. Fortinet is well-positioned to capitalize on this expansion of firewall deployments and form factors as we've been delivering hybrid mesh firewalls for years on a single operating system. Second, the company was founded 20 years ago on the belief that the convergence of security and networking will become an industry standard. Gartner shares this belief, noting they expect the size of secure networking market to overtake the traditional networking market by 2030. We believe secure networking at scale works most effectively on ASIC technologies. Since its inception, Fortinet has been developing proprietary ASIC technologies to build application-specific solutions to support convergence that traditional CPU-based solutions are less efficient at supporting both networking and security.
Third, vendor and product functionality consolidation strategies continue to become more commonplace. Looking to Gartner here again, they note 75% of organizations are pursuing a cybersecurity vendor consolidation strategy in 2022, up from 29% in 2020. Our integrated FortiOS platform allows customers to converge networking functionality with security capabilities while consolidating cybersecurity products and functionality. With FortiASIC's significant computing power advantage, FortiOS can consolidate more security functions and solutions while maintaining our performance and cost advantage. Specifically, FortiOS supports many security applications, including network firewall, SD-WAN, SASE, 5G, Wi-Fi security, ZTNA, VPN, and SSL, with a variety of use cases for each security application. For example, firewall use cases include data center, branches, edges, virtual, cloud native, micro-segmentation, both east-west and north-south, and Firewall as a Service.
Our convergence and consolidation strategy provides security across our customers' entire digital infrastructure while lowering their operating costs. All right, now let's take a closer look at the first quarter. Billings grew 30% to $1.5 billion, driven by enhanced platform technology solutions. In terms of industry verticals, government and financial services topped the list as a percentage of total billings, with financial services up over 40%. Construction, media, and utilities were all up at least 50%. Billings growth benefited from better than expected backlog contribution. While the backlog cancellation rate increased QoQ, it was lower than we had forecasted in our model. We continue to believe there's an elevated cancellation risk in future periods for networking equipment backlog. Bookings grew double digits in the quarter off a challenging comparison to 50% growth in the first quarter of last year.
We continue to see success with our strategy to expand further into the large enterprise segment, with the number of deals over $1 million increasing 38% to 124 deals, and billings on these deals increasing 50%. One of these deals was an eight-figure expansion and upsell opportunity at a Fortune 50 retailer. The retailer was looking to replace their firewall point solutions with a more holistic cybersecurity solution. After purchasing FortiManager and FortiAnalyzer in the fourth quarter of last year, this customer selected FortiGate VMs for a very competitive process for their 2,000 store locations as part of our new FortiFlex program. FortiFlex is a new points-based consumption program supporting hybrid mesh firewall deployments, as well as a variety of other security solutions.
The customer selected Fortinet due to the substantial value offered by our unified platform and the significant technical requirements. In the first quarter, we added approximately 6,100 new logos, reflecting the support of our channel partners through their investments and the investments we've made in them. Average contract term was flat YoY at 27 months and down one month QoQ. Turning now to revenue. Total revenue grew 32% to $1.26 billion, driven by strong demand for core and enhanced platform technologies, increasing 23% and 50% respectively. Product revenue of $501 million increased 35%, despite the very difficult comparison to last year's first quarter of 54% with its very strong contribution from acquisitions.
Product revenue growth was driven by strong growth in enhanced platform technologies, improving supply chain dynamics, and our earlier pricing actions. Service revenue was up over 30% to $762 million, the highest growth rate in services since 2016. The average number of days between when the customer purchases and subsequently activates a security service contract declined slightly sequentially and remained elevated on a YoY basis. Service revenue growth was closely aligned with our short-term deferred revenue growth rate in recent periods. Short-term deferred revenue growth was over 30% for the fourth consecutive quarter. Total gross margin of 76.3% was up 190 basis points, including a 440 basis point increase in product gross margin to 61.8%.
Product gross margin benefited from earlier pricing actions, improved discounting, and easing cost pressures. Service gross margin of 85.9% ticked up 70 basis points as price increases offset increased investments in data centers and points of presence or PoPs. Operating margin of 26.5% was up 450 basis points due to the strong gross margin performance of foreign exchange benefit and revenue growth that was 10 points higher than our 22% headcount growth. As previously noted, 26.5% is our highest ever first quarter operating margin as a public company. Looking at the statement of cash flow summarized on slides seven and eight.
Free cash flow was a quarterly Fortinet record at $647 million and benefited from elevated receivables in the fourth quarter of last year and the subsequent cash collections, as well as the record-setting operating margin and the timing of CapEx projects. Adjusted free cash flow, which includes the real estate investments, was $662 million, representing a 52% adjusted free cash margin and our highest margin since our 2009 IPO. We've come to expect some quarterly variances in our free cash flow results, with the first quarter often stronger due to the seasonally strong fourth-quarter billings. Capital expenditures were $30 million, including $15 million of real estate investments. This was lower than expected due to the timing of real estate activities. Cash taxes were $21 million.
The board increased the company's share repurchase authorization by $1 billion. The total available share buyback authorization is now $1.5 billion for repurchases through February 2024. Looking forward, we are excited about the growth drivers that we've discussed previously, as well as our new single vendor Universal SASE offering. Our Universal SASE offering delivers a comprehensive solution that extends the convergence of networking and security from the edge to remote users while helping teams drive operational efficiency and reducing complexity and costs by consolidating vendors. In fact, Gartner predicts that by 2025, one-third of new SASE deployments will be based on a single vendor SASE offering, from 10% in 2022. As we bring Universal SASE to market, we expect to make various investments, including increasing our PoPs.
Our guidance reflects the impact of these investments to both our gross margin and capital expenditure estimates. Moving to guidance, I'd like to review our outlook for the second quarter and full year summarized on slides 10 and 11, which is subject to the disclaimers regarding forward-looking information that Peter provided at the beginning of the call. For the second quarter, we expect billings in the range of $1.56-$1.6 billion, which at the midpoint represents growth of 21%. Revenue in the range of $1.28-$1.32 billion, which at the midpoint represents growth of 26%. Non-GAAP gross margin of 75.5%-76.5%. Non-GAAP operating margin of 24.5%-25.5%.
Non-GAAP earnings per share of $0.33-$0.35, which assumes a share count of between 790 million and 800 million. Capital expenditures of $80-$110 million. A non-GAAP tax rate of 17%. Cash taxes of $35 million, which is lower than our prior expectation as the deadline for certain tax payments has been extended to the fourth quarter. The second quarter guidance assumes backlog decreases during the quarter. For the full year, we expect billings in the range of $6.75-$6.81 billion, which at the midpoint represents growth of 21%. This guidance assumes a low single-digit impact of billings growth from backlog.
Revenue in the range of $5.425-$5.485 billion, which at the midpoint represents growth of 23.5%. Service revenue in the range of $3.37-$3.4 billion, which at the midpoint represents growth of 28%. The service revenue guidance implies product revenue growth of 16%. Non-GAAP gross margin of 75%-76%. Non-GAAP operating margin of 25%-26%. Non-GAAP earnings per share of $1.44-$1.48, which assumes a share count of between 795 million and 805 million. Capital expenditures of $400-$450 million due to the continued cloud data center and facilities investments. Non-GAAP tax rate of 17%.
Cash taxes of $390 million with approximately $300 million in the fourth quarter. The full year estimates assume backlog returns to historical levels later this year. As we wrap up the prepared remarks, maybe one additional observation. Over many years, the Fortinet team and its partners has offered very solid and consistent level execution across a wide range of economic cycles and other challenges. Like many others, we see a level of economic uncertainty in front of us, and we look forward to this possible challenge in delivering on our goals. I'll now hand the call back over to Peter to begin the Q&A.
Peter Salkowski (SVP of Finance and Investor Relations)
Thank you. As a reminder, during the Q&A session, we ask that you please limit yourself to one question and one follow-up question to allow others to participate. Chris, please open the call for questions.
Operator (participant)
Thank you. At this time, we'll conduct a question-and-answer session. As a reminder, to ask a question, you'll need to press star one one on your telephone and wait for your name to be announced. To withdraw your question, press star one one again. Please stand by while we compile the Q&A roster. Our first question comes from Brian Essex of JPMorgan Chase & Co.. Your line is open.
Brian Essex (Executive Director)
Hi, good afternoon. Thank you for taking the question and congrats on a nice quarter, particularly in a tough macro. Maybe, Keith, for you, nice acceleration in services revenue this quarter, and I know Ken talked about more effectively selling or selling value-added services, secure services into your installed base. How much was due to the, you know, better attach rate of secure services versus changes in registration policy or pricing increases in the quarter?
Keith Jensen (CFO)
Yeah. Great question, Brian. And I think, when we peel back the onion and look back, we saw in FortiGuard, which is the security services part of the business, and you'll see this in our SEC filings next week, growth was 35% for FortiGuard. We started looking more deeply at that. To Ken's point, what we saw there were areas like SaaS products and offerings that are attached to existing customers. Certain cloud offerings, what we call pay-as-you-go, if you will, were attached to it as well. I would describe those as being a significant driver to the growth. I think the price benefits would probably take the number two slot, and then the number three slot would be some changes in the registration behavior.
By that I mean customers did register a little bit faster, in the first quarter, but that lag or that registration policy change that we implemented in the first quarter, I would specific call out as not really having an impact in the first quarter, nor did we really expect one. Kind of in order, I think it was selling into the install base, price increases, and then some light improvements in the registration behavior.
Ken Xie (Founder, Chairman, and CEO)
Yeah. Also with the new FortiOS 7.4 we started launching, we started to have a more function which can also enable much more new service going forward, for both the current customer installation base and also for new customers.
Brian Essex (Executive Director)
Got it. That's helpful. Maybe as a, as a follow-up, Keith, you know, I think you commented on lower than expected cancellation rate. I know the question will be asked, impact on billings from, you know, backlog training and what some of your assumptions are, particularly given what you see in macro. I know you talked about you expect to be at normalized rates for backlog by the end of the year, but maybe if you can contextualize or quantify that to the extent that you're able to.
Keith Jensen (CFO)
Yeah. I think in the guidance, particularly as we look at the full year, you know, it's kind of difficult to figure out exactly which quarter some of that backlog is gonna end up in or be canceled. For the full year, I think we talked about low single digits growth that would be coming from the backlog. I do think that, you know, the risk to cancellations increases as the year progresses. By that I mean if, you know, if a customer's only been in backlog for a week or a month or something like that, there seems somewhat less probability that they're gonna cancel. The longer it takes to deliver on that backlog, I think the cancellation risk continues to increase.
Ken Xie (Founder, Chairman, and CEO)
Also, a point is really, you mentioned go back normal end of the year. We see it later this year. It could be middle, could be towards the end. In Q1, I say the operation team did a great job to reduce the backlog, which also helping secure more customer and lower some cancellation rate.
Brian Essex (Executive Director)
Got it. Very helpful. Thank you both very much.
Operator (participant)
Thank you. One moment for the next question. This question comes from the line of Gabriela Borges with Goldman Sachs. Your line is open.
Gabriela Borges (Managing Director and Head of US Software Equity Research)
Good afternoon. Thank you. I have this for Ken or for Keith. It's a follow-up question on forecasting, which is we've heard so much noise in the industry around supply chain and COVID catalyzed product cycles. How do you all think about true demand and potentially plan around the risk of demand growing faster than expected, given you've had a very strong couple of years? Thank you.
Ken Xie (Founder, Chairman, and CEO)
I think probably some of that more referred to the traditional network security, secure some enterprise, deploy in enterprise. We do see that our solution has a much broader use case and also expand to much bigger market opportunity than the traditional enterprise firewall. Also the SD-WAN OT is also see very strong growth continuing to helping drive both the new customer and also expanding the current existing customer. In the S&P space, it's a relatively green field. We also see pretty healthy, faster growth, probably even faster than the traditional enterprise, which is more replacement. I think all this I see contributing to pretty healthy, keep it saying double-digit growth in the future for the whole network security space.
Gabriela Borges (Managing Director and Head of US Software Equity Research)
Yes. That makes sense. Thank you. Ken, the follow-up is for you, which is as you start to execute more on the convergence of selling into the networking budget or the convergence of networking plus security, when you look at the classic networking competitors, how do you think about the barrier or the limitation for classic networking vendors to get more into security and become more competitive in the convergence over time?
Ken Xie (Founder, Chairman, and CEO)
I could say from the product architecture, it's very different because security need much more computing power and to handle the lot of unstructured data, which the traditional networking company probably more based on some structured data, handle some fixed next protocol, and much less computing power needed to process data compared to the network security. That's where... Also you would have to implement the function, and the new function come up every year in the software first, and then keeping enhancing, improving the performance leverage ASIC. Also we don't see networking company doing some of that. They probably little bit slow on where to come up a new function for the security space.
All kind of have a different architecture to really supporting the secure computing needed for network security. That's we. So far we have not seen the traditional networking company really come close. They did some acquisition, so far I don't see they really come up to my scenes to meet a new demanding from customer, both on the function and also on the surveys on the infrastructure change.
Gabriela Borges (Managing Director and Head of US Software Equity Research)
Thanks for the detail. Congrats on the quarter.
Ken Xie (Founder, Chairman, and CEO)
Thank you.
Operator (participant)
Thank you. One moment for the next question. The next question comes from the line of Fatima Boolani of Citi. Your line is open.
Fatima Boolani (Managing Director and Co Head of US Software Equity Research)
Thank you. Good afternoon. I appreciate you taking my questions. Ken, just a technology vision question for you. You are very, and the team is very bullish on the SASE opportunity that was very apparent at the Accelerate conference as well. I'm curious as to why you're taking the effort to build out data centers and points of presence to deliver your Universal SASE strategy versus maybe some of your peers and competitors who are maybe relying on a third-party providers and hyperscalers. Then I have a quick follow-up for Keith, please.
Ken Xie (Founder, Chairman, and CEO)
Yeah, first of all, SASE, kind of vision a little bit different than some of our competitor. We do believe need to be a universal, need to be more broadly deployed and also more leverage a lot of service provider infrastructure. It's kind of a hybrid environment instead of a cloud-only SASE solution. We do keeping expanding some of our path because there's a. Definitely there's some user, like whether, depends on work from home or some other cloud SASE to secure some of their traffic there. On the other side, there's a huge base of customer, need to using SASE or kind of service model leverage both service provider all their current infrastructure and even on-site appliance.
That's where in certain point we also see our FortiGate and FortiAP, kind of our agent helping forward the traffic for the FortiGate, to process all this SASE traffic there. That's the reason we kind of put SASE in a single OS, both on the networking side of function like SD-WAN, 5G or other, plus the security like a CASB, DLP, all these firewall service, all these things. That's where we have a more integrated, more broadly distributed and leverage whatever the hybrid infrastructure SASE solution there. That's also the reason we continue to build some of the PoP.
It's a little bit different than some other leverage certain cloud provider, because we do see the cloud provider potentially also can be the service provider to offer SASE. Also from the ROI point of view, even have a little bit more investment from the beginning to build some PoP ourself, but long term will be more profit model, so we'll be, have a better margin. That, we will take some time to make sure we build a healthy ecosystem, both with our partner and also with the investment for long-term benefit.
Fatima Boolani (Managing Director and Co Head of US Software Equity Research)
I appreciate that detail, Ken. Keith, just quickly for you, kind of a tactical question on the billings outlook. You're raising the full year by less than half of the beat and the raise when I think about the first half. Maybe from a bottom-up perspective, can you walk us through what sort of underpinning that conservatism? I can appreciate the macro is jittery, but if you can kind of give us some more tangible considerations you're thinking about in terms of a bottom-up perspective on getting to that billings guide for the full year. Thank you.
Keith Jensen (CFO)
Yeah. I would say, one, just kind of as a general thought, I think that raising it, to some extent I think probably gives you a little bit of a, of a message that we feel good about our strategy and the execution that, the level that we can bring to the, to the market. More specifically and more tactically, as we look through the, look to the second half of the year, you know, there's probably a little more, you know, rigor and effort, if you will, in trying to look at what we see coming in the second half of the year. I would give you the, probably the two headlines that we're looking at. One is we're still very, very pleased with the pipeline.
You know, the pipeline continues to grow, continues to be, you know, well above anything that we're talking about growth rates for the company for the full year. You know, I think the nuance that, and maybe it's not even a nuance really, that's come into play now is more about close rates. It's not just as simple as taking your pipeline, assuming you're gonna have close rates that were at the same level they were in prior periods. That's when we use the term close rates, not a suggestion that deals are getting lost, but this continual cycle that we seem to be in, where some of the larger enterprise deals in particular are taking longer. They're pushing out a lot of pushes. It's not that there's been an increase in losses, but the continual push.
With that in mind, you know, I think a fair amount of attention looking at the full year guidance on what we really think our close rates may be for the second half of this year.
Fatima Boolani (Managing Director and Co Head of US Software Equity Research)
Thank you.
Keith Jensen (CFO)
Uh-huh.
Operator (participant)
Thank you. One moment for the next question. This question comes from the line of Saket Kalia of Barclays. Your line is open.
Saket Kalia (Managing Director)
Okay, great. Hey, good afternoon, everyone. Thanks for taking my questions here. Ken, maybe just to start with you. Great to see Fortinet sell the whole breadth of the platform, particularly within the enterprise. Could you just maybe talk about anything that you can do to make it easier for customers to consolidate spending with Fortinet? You know, whether that's an enterprise license agreement or any other thing that sort of makes it easier to, you know, to combine, you know, consolidate those vendors, which was a theme I think was talked about earlier.
Ken Xie (Founder, Chairman, and CEO)
We definitely see some healthy growth of our enterprise agreement, and also we working closely with our channel partner, with our service provider, also leverage their connection, their resource, build a healthy ecosystem, to grow together. I also see the from enterprise level, they also see the benefit of consolidation, definitely. Also not just consolidate some of the treated product, but also on the expanded infrastructure group beyond the traditional network security. That's also we see pretty healthy growth, like a Q, and we do see that we could enhance technology side also has pretty healthy growth.
Yeah, the sales force also, you can see the number of $1 million deal, both on the number and also on the dollar-wise, has a pretty healthy growth, continue accelerate and grow beyond the total building growth. That's, that's a pretty healthy trend we see going forward to helping customer consolidate.
Keith Jensen (CFO)
Yeah. Saket, maybe just Keith, just to go a little deeper on what Ken's talking about there, I'll give you know, maybe four quick examples. You know, enterprise agreement is something that we've been doing now for probably a couple of years. We track those as a, in some ways, as a different line of business in terms of the growth rates. Particularly as we've moved into the enterprise, you know, I think it's been very important to be there and we've been very successful with it. I think another illustration of trying to make it easier for customers was the example of the large retailer we gave on the call today, and we talked about the points program, right?
Which is an easier way, I think, sometimes for them to get on board and consume more of the products. I think also then, you know, when we sell, you know, making sure that our sales people are well trained on the value proposition that we're offering, not just on the cost of the appliance or the throughput of the performance, but also, you know, what it means to the customer's management costs and overhead costs as well. I think those types of things are all going into play here to support what Ken was talking about making it easier for customers to consume our products.
Saket Kalia (Managing Director)
Got it. That's super helpful. Keith, maybe for my follow-up for you. Great to see that 30% growth and acceleration in services revenue. Maybe the question is: How do you think about what portion of your existing subscription base hasn't seen that cumulative impact of the price increases you've done yet, right? Like, clearly the price increases on product have been fully baked, but how much of the base, or maybe how long will it take for the subscription base to fully realize that pricing as well?
Keith Jensen (CFO)
Yeah, great question. I, and I think I didn't really look at the numbers closely this quarter, we did last quarter. A couple of things to keep in mind. You know, average contract term, call it 27 months, you know, if all the contracts are 27 months, you can do that math. They're not, you know, some are one and some are three-year contracts in terms of the renewals that are coming through. Probably one in five-year contracts. Sorry, Peter. Thank you for that. It does have a long tail.
Again, I refer you back to, you know, how many quarters or how a few years that we talked about seeing the uplift that came when we converted to 24 by seven support from eight by five, you know, that continued to provide a benefit for several years. I think the tail gets smaller, obviously, as you go further out. I think the majority of what's, of the existing contracts, more than 50% are under the new pricing.
Operator (participant)
Very helpful. Thanks, guys. Thank you. One moment for the next question. The next question comes from the line of Shaul Eyal of TD Cowen. Your line is open.
Shaul Eyal (Managing Director of Equity Research)
Thank you. Good afternoon. Congrats on results and guidance in a tough macro. Keith, maybe starting with you. Can you comment, can you provide us with some color about the financial vertical performance this quarter?
Keith Jensen (CFO)
Well, financial services have always been one of our, I shouldn't say always, but for a long time they've been in the top three. It can be a bit feast or famine there with some very large deals in the quarter. I don't think there was anything that was, it was number two in this particular quarter. Thank you, Peter. I don't think there were any really large deals that drove that number. I think it was, you know, we saw growth and success not only in the U.S., but also internationally, particularly in Europe. I think it was a strong quarter for us in that area.
Shaul Eyal (Managing Director of Equity Research)
Got it. From a product mix perspective, the entry-level performed the best, you know, versus the high end. Is that just a mix or a macro reflection? Also, did you have any eight-digit wins this quarter?
Keith Jensen (CFO)
We talked about, yes, we did.
Shaul Eyal (Managing Director of Equity Research)
Okay.
Keith Jensen (CFO)
I think we talked about one in the script, just a moment ago, and I think we commented it was an eight-figure deal, if I'm not mistaken, right? Without giving a specific number. Yeah. I don't recall if there was a second eight-figure deal. There was a second eight-figure deal.
Ken Xie (Founder, Chairman, and CEO)
Yeah. Our SMB had pretty healthy growth. Like I said, SMB is a more green field for the network security. We do see more and more SMB need a network security to protect their business, especially comes from some of the ransomware attacks. On enterprise, because it's a kind of more replacement and also a lot of enterprise kind of maybe the business arm and T&D refresh some of the hardware more dependent on the service. That's impact some of the high end. The other benefit for some of the low-end middle range is really most, I say most, IC one and some of the OT deployment may be more towards the low and middle range.
Shaul Eyal (Managing Director of Equity Research)
Got it. Thank you. Appreciate it. Well done.
Ken Xie (Founder, Chairman, and CEO)
Thank you.
Operator (participant)
Thank you. One moment for the next question. This question comes from Rob Owens of Piper Sandler. Your line is open.
Rob Owens (Senior Research Analyst)
Thank you very much, and good afternoon. Thanks for taking my question. Wanted to start around OpEx or the corollary operating margin and very strong first quarter here. I think you mentioned it was the strongest Q1 that you've had since you're public. If I go back through results since you've been public, Q1's never really been the high watermark from an operating margin standpoint. Walk me through your thought process as the rest of this year plays out. Was there some aberration in Q1 that really helped drive that, or just a lot of conservatism as we look ahead?
Keith Jensen (CFO)
Yeah, I think we called out three things and maybe focusing on two. One, we had a very strong gross margin in the quarter, and I'll elaborate on that in a moment. Then also FX, you know, continued to provide a tailwind. More commentary about the gross margin, particularly the product gross margin as we move through, you know, the supply chain challenges and then into inflation, et cetera, over the last couple of years, I think we've talked publicly that our goal was to try and keep the product gross margin around 61% or so. The fourth quarter came in obviously very low. We did not anticipate that we'd be able to time our price increases and the cost increases perfectly, so they went through the income statement in the same quarter, so to speak.
With that, I think you saw a little bit of pressure in the fourth quarter, then you saw it kind of revert in the first quarter. I think longer term, you know, we also look at product gross margin as an opportunity sometimes for us to continue to invest in growth. I think we've started the first quarter gross margin certainly well above that band that I just talked about. With that in mind, you know, as we start to see some of the costs moving out of the equation, you know, and we introduce new products, you know, I think we'll be looking at that in terms of is there an opportunity there to make certain investments in growth while maintaining the margin commitments that we've talked about.
Rob Owens (Senior Research Analyst)
Great. As a follow-up, did wanna touch on the OT business and the strength you're seeing there. Can you talk a little bit from a go-to-market standpoint and some of the channel programs? 'Cause it does seem like there's some new, large channel partners out there that are very excited about the opportunity. Thanks.
Keith Jensen (CFO)
I think OT, we do look at. I mean, you're always trying to organize your sales force around verticals, geographies or what have you. I think when we started to see the opportunity in OT several years ago, you know, Patrice and Ken made a decision to start separating that out and having really a separate sales function and some people that specialize in that. I do think that we probably got, you know, some first-mover advantages, by doing that, particularly as we look at Europe and then quickly followed thereafter by the U.S.
Yes, there are some large names that are, you know, in that space that are providing technology, not security technology, but technologies in the OT space, that have been very receptive, if you will, to conversations and opportunities to meet with us.
Operator (participant)
Thank you very much. One moment for our next question. The next question comes from Adam Borg of Stifel. Your line is open.
Adam Borg (Managing Director)
Awesome. Thanks so much for taking the questions. Just for Ken or Keith, obviously, it's great to see the strong collections and the record free cash flow. You also talked about contract terms being consistent YoY. I was just curious though, just given the tougher macro, are you seeing any pushback by customers around willingness to pay up front? Then I have a follow-up.
Keith Jensen (CFO)
Well, first of all, I wanna revel in the $600 million free cash flow, in which I'll be doing it for several more quarters. I kind of let people know that a lot of the things fell our way in the quarter. There's always, you know, the conversation in part of the sales cycle, if you will. You know, the customers want a one-year, three-year, five-year deal. You know, certainly in an environment where interest rates have gone up, I think there's many more conversations that exist, you know, around payment terms and things like that. You know, I do believe that, you know, just as we just talked about in the second quarter of 2020 when COVID hit, we have a very strong balance sheet.
We obviously have very strong margins, you know. It's appropriate for us to look at that as opportunities to leverage our balance sheet. Sometimes that may be in the form of extended payment terms or what have you. In our income statement in the form of, you know, how we wanna go about discounting and supporting growth. I think that, you know, again, the strength that we've had, you know, we have the ability to do those things. If the question is around what are we seeing from some of the enterprise customers. Ken's seeing a lot of this as well, you know, do we see deals that go from five years to three years? Sure. Is it more than we've seen in the past?
You know, I kind of look back at the contract term data point that we give and say maybe, but not a lot, kind of a thing. On payment terms, you know, the channel has always offered a financing function. I think they prefer to provide the financing function. I think we provide support to the financing function to the channel, by making capital available to them through payment terms.
Adam Borg (Managing Director)
That's really helpful. Maybe just as a quick follow-up, you know, headcount was up a little bit over 600 people QoQ, up over 21.5% YoY. Just curious how we're thinking about headcount growth either in Q2 or later this year. Again, just given the macro. Thanks again.
Ken Xie (Founder, Chairman, and CEO)
Overall, if we look at both headcount and headcount cost, probably the same pace, company grow the top line and also try to at the same time try to improving some efficiency there. We're now looking for headcount growth above the top line. We feel there's still some, quite some area we also need to do some more investment, long-term investment. The company so far we feel we have a pretty healthy finance model. This also could be the opportunity to also gain in some market share.
Adam Borg (Managing Director)
Great. Thanks again.
Operator (participant)
Thank you. Thank you. As a reminder, to ask a question, please press star one one on your telephone and wait until your name is announced. Please stand by for the next question. This question comes from Ittai Kidron from Oppenheimer & Co.. Your line is open.
Ittai Kidron (Managing Director and Senior Analyst)
Thanks. Hey, guys, nice results. My first question, I guess is on the U.S. enterprise. Not U.S. in general, but just the enterprise vertical. Clearly one of the most important growth opportunities for you long term. Can you talk about progress over there, win rates, displacements, and is the macro making things easier or more difficult for you specifically in the U.S.?
Ken Xie (Founder, Chairman, and CEO)
First, we continue to invest in the U.S. enterprise. We also see the huge growth potential for us because we have relatively small market share and with all the strong product technology we have. On the other side, the big environment definitely slowed down some of the enterprise making certain decisions whether to refresh or something like that. On the other side, our solution has a better lower total cost of ownership and also can expand beyond the traditional network security and also helping customer to consolidate. I think all this combined together, we do see the U.S. enterprise, definitely is a strong growth area for us.
Ittai Kidron (Managing Director and Senior Analyst)
Okay, thanks. Maybe a follow-up on the competitive side then, Ken, maybe you can talk about what have you seen out of your competitors here in the U.S.? Any kind of abnormal activity from discounting or otherwise?
Ken Xie (Founder, Chairman, and CEO)
I think during the slowdown of some of the big environment, definitely, the competitor is starting to more aggressive, whether on some discount or offer some free, some term of the free, some percentage of free service. From our angle, we see we have much better product position, much broad like infrastructure coverage and better service. Also both on the performance angle, the product definitely has performed much better for the same function, same cost and same time. Our service also has much more value and cost lower than competitors. For us, we have not experienced like a price pressure or discount pressure.
It's more about how we can increase the coverage, increase the lead gen, the pipeline, and also to meet the customer need in this big environment change. Very good. Thank you.
Keith Jensen (CFO)
Yeah, I would think that what Ken talks about I think is fantastic. I think keep in mind, you know, we don't, you know, we have a very, as we kind of talked about on the March 3rd, a very diverse customer base, if you will, between being international, between being very large, mid, small, and SM, and MSSPs, et cetera. I don't wanna put a policy in place that covers every geography, and it covers every customer size. I think what you're really talking about here is something that for us represents, you know, 15% of our business, maybe just a little bit less.
Because it's at that size, it's something that we can really more, I think, target our responses to as we get deeper into the selling function as opposed to some broad announcement that, you know, we're gonna give away services for two years or something like that.
Ken Xie (Founder, Chairman, and CEO)
Very good. Thank you.
Keith Jensen (CFO)
Uh-huh.
Operator (participant)
Thank you. One moment for the next question. This question comes from the line of Angie Song with Morgan Stanley. Your line is open.
Angie Song (Research Analyst)
Hi. Thank you guys so much for taking my question. I'm on for Hamza Fodderwala at Morgan Stanley. Could you just share a little bit more about your current interest around the SASE or current customer interest around the SASE product, and what are some of the responses around this so far?
Ken Xie (Founder, Chairman, and CEO)
It's a pretty strong growth, and also we're working with a lot of our service provider, both on the infrastructure side, our security service side, and offer the SASE, because we do believe SASE should be an ecosystem with a lot of player, instead of just a vendor offer their own SASE. Because a lot of, I'd say probably most of the customer, they prefer some of their data being processed, controlled themselves, whether some private SASE or some data sovereignty, keeping the data within certain geo. So that's where we see the SASE approach, we call Universal SASE, give the customer flexibility to offer both a cloud-based or on-premise based or kind of legacy service provider infrastructure, will be more benefit the whole industry long term.
That's where even sometime we kind of take a little bit more time to develop all the SASE function in a single OS, but that's making more easy for the customer, for the service provider to deploy SASE to fit their need and their environment. We see a very well healthy pipeline and the strong growth, kind of our salary growth. That's also based on kind of a more healthy margin, kind of model instead of losing money all about growth. We want to maintain that kind of model and also working closely with a partner to offer kind of SASE together to the customer.
Angie Song (Research Analyst)
Got it. Thank you. Just one more around profitability. How are you guys thinking about, slows down over the next few years, and, where do we expect to see that margin leverage?
Keith Jensen (CFO)
Angie, can you repeat that? You cut out at the beginning of that question.
Angie Song (Research Analyst)
Yeah, no worries. The question is around profitability, and I was just wondering, what you guys are thinking about upside to profitability as growth slows down. Where should we expect to see that margin leverage?
Ken Xie (Founder, Chairman, and CEO)
We see the mid-term model will be $10 billion by 2025, with a non-GAAP operation margin at least 25% for each year in the next three years.
Angie Song (Research Analyst)
Got it. Thank you.
Keith Jensen (CFO)
Yeah. I think the one thing, Angie, and, I think Hamza, we've talked to Hamza about this before as well, keep in mind, you know, two-thirds of the business roughly is service revenue, and that's producing a gross margin that's in the mid-eighties. And that's, those are longer term contracts. I think we, the business model is such that we'd have time to react if there was something really dramatic that happened in, in the industry. But part of that, for that to happen, I think you'd probably have to see some sort of shift in the behavior of the bad actors, the nation states, the organized crime groups, et cetera, and we don't see that that's on the, on the landscape.
Angie Song (Research Analyst)
Great. Thank you so much.
Keith Jensen (CFO)
Uh-huh.
Operator (participant)
Thank you. Please stand by for the next question. This next question comes from the line of Tal Liani of Bank of America. Your line is open.
Tal Liani (Technology Analyst)
Hey, guys. What we've seen with good companies in the last two quarters is that they make great numbers. When you look at the composition, new customers are slowing down and sales to existing customers are going up. We've seen it through multiple companies in the space. The question is whether you can provide us with some data on sales to existing customers versus new customers. How is the current environment on customer acquisition, on new customer acquisition? Thanks.
Keith Jensen (CFO)
Yeah. As a reminder, Tal, good to hear from you again. you know, if you think of the business being, you know, extremely diversified, whether that's geographically or by customer segments, 1/3 small, 1/3 mid, 1/3 large. We specifically called out in the script that we added over 6,000 new logos in the quarter. obviously and that's probably a growth rate that's, you know, easily into double digits. New logos take a while to really produce revenue for us. It tends to be, you know, less than 10% of total revenue from the new logo, so it creates the opportunity to continue to sell into them.
You know, kind of to Ken's comment a moment ago and to your question here, you know, do we see large enterprises in the U.S. Yeah, still moving forward robustly with all their various digital transformation projects. I think that the word on the street is, you know, that that slowed down a little bit. In that environment, I do think that incumbents sometimes have an advantage, but also a cost of performance argument and debate is something that you see customers perhaps more receptive to in the current macro environment.
Tal Liani (Technology Analyst)
In the current macro environment, is the duration of contracts going down? Or-
Keith Jensen (CFO)
No, again-
Tal Liani (Technology Analyst)
is it more-
Keith Jensen (CFO)
It's flat. It was flat YoY, down one month, QoQ.
Tal Liani (Technology Analyst)
Got it. Okay, thanks.
Keith Jensen (CFO)
Which as somebody reminds me in the room very politely, every first quarter is down one month.
Tal Liani (Technology Analyst)
Got it.
Ken Xie (Founder, Chairman, and CEO)
Sequential.
Tal Liani (Technology Analyst)
Yes.
Operator (participant)
Thank you. One moment for the next question. This question comes from the line of Andrew Nowinski of Wells Fargo. Your line is open.
Andrew Nowinski (Senior Research Analyst)
Thank you, and congrats on the nice quarter. I wanted to ask about your SASE offering as well. You talked at the Accelerate conference about, I think having eight-10 new use cases driving demand for the firewall. I'm wondering if SASE could be one of those use cases as well, meaning, you know, is the firewall appliance a critical component of your SASE offering?
Ken Xie (Founder, Chairman, and CEO)
Yes, SASE definitely is a one of the use case, especially the Universal SASE or sometime they call the private SASE. For some customer, they or some service provider, they want to have more control of their data. That's we see is yeah, both SASE, like the service model customer benefit service provider has a big value-added one, but at the same time, gives them the flexibility of whether for some traffic to the cloud or to the PoP or have a process on premise and by the appliance.
That's we see the huge benefit of Universal SASE solution, which is very different than some other SASE player and a lot of customers and the partner are very interested to this Universal SASE approach.
Andrew Nowinski (Senior Research Analyst)
Thanks, Ken. Maybe a question for Keith, just as it relates to your CapEx. You talked about a component of that being used to build out more PoPs to support the SASE offering. Like, how should we think about CapEx and that investment beyond 2023 as you continue building out your network?
Keith Jensen (CFO)
Well, Ken and I are smiling at each other. We've had this conversation. I think I've been here for nine years as of this week. One thing I've come to appreciate is that Ken behaves like a long-term investor. With that in mind, owning critical real estate assets tends to have a better payback than leasing them over an extended period of time, whether that's in R&D facilities, whether that's in manufacturing or warehouse facilities, or that as you, as we move into the, into the SaaS market as well as other cloud offerings, it's not just investments in SASE, if you will, but it's also investments in larger data centers in order to deliver various, you know, cloud-based services and solutions.
I think you've heard us talk about that in the last several earnings calls in the guise of, you know, data centers having an impact on margins for services and CapEx spending. I don't think there should be a surprise there, but I think it is a, an indication of our, of our looking to expand into, you know, more fully into some of these other markets.
Andrew Nowinski (Senior Research Analyst)
Got it. Thank you.
Keith Jensen (CFO)
Mm-hmm.
Operator (participant)
Thank you. One moment for our final question. Our last question comes from the line of Shrenik Kothari from Baird. Your line is open.
Shrenik Kothari (Senior Research Analyst)
Hey, thanks for taking my question. For Ken or Keith, I think Keith, you mentioned about the financial services up over 40%, which is surprisingly strong and contrary to what we are hearing from your peers and competitors. Can you expand a bit about upon the underlying drivers? I know you touched upon it, but I just wanted to expand on the geographical diversity or is it increased impetus for vendor consolidation that is benefiting you guys in that vertical? If you can just elaborate, and then I have a quick follow-up.
Keith Jensen (CFO)
Yeah. I would say it's all of the above. It's happening geographically. I think it's happening with customers that we took down earlier that are expanding with us with additional firewalls and additional security or additional services as well. I think the market, if you will, financial services, if you step back and look at what's happening there, specifically the firewalls over the last several years, you know, there's probably two legacy vendors there that when their contracts are up for renewal, and we've talked about this for a long period of time, now they're exposed. It creates an opportunity to come in for a competitive displacement. I think that some of the other comments or questions today is, you know, is it more difficult in this environment for competitive placements?
I mean, sure, you got to work a lot harder to make it happen. You got to make your value proposition more well known. I think again, I think it's expansion. I think it's opportunity to displace incumbents, and I don't think it's specific to any one particular geography.
Ken Xie (Founder, Chairman, and CEO)
Also from technology angle, we have a two huge advantage. One is for the internal segmentation of security data center. Because the ASIC advantage we have, we can deploy in a very high speed environment, which a lot of us financial service provider, they do need to secure their kind of internal segmentation there. The other part really, some of finance service also starting to supporting work from home, working from remotely, which we also have a large super solution with our ASIC-based like a small appliance. Can supporting this kind of very broad infrastructure approach combined with like SD-WAN or the other 5G, 4G network and security together. That's give us huge advantage from the partner angle.
Shrenik Kothari (Senior Research Analyst)
Got it. Thanks a lot, Ken, Keith. Just a quick follow-up. You guys of course touched upon the expansion opportunity in the form factors. Of course, your peers and companies have spoken about unit expansion pressures and how the product unit growth is kind of normalizing. Just wondering, given that you guys give examples of this eight-figure expansion and upsell opportunity, replacing kind of firewall with a holistic solution, can you talk about like expansion drivers broadly? Like, are you seeing mostly upsell and expansion in form factors versus the units? Just wanted to get some clarification there.
Ken Xie (Founder, Chairman, and CEO)
Probably both. We do see the expanding of both the unit and also upsell, cross-sell of the entire Fortinet Security Fabric, which has 53 products. So that's where both our internal sales force and also partners starting to do a lot of upsell, cross-sell for the whole fabric. The same time, because we combine networking security and more function together, have multiple case, which also the unit shipment also starting keeping grow quite nicely.
Shrenik Kothari (Senior Research Analyst)
Got it. Thank you a lot, Ken. Appreciate it.
Ken Xie (Founder, Chairman, and CEO)
Yeah, thank you.
Operator (participant)
Thank you. That concludes the Q&A segment. I'll now turn it back over to Peter Salkowski for closing remarks.
Peter Salkowski (SVP of Finance and Investor Relations)
Thank you, Chris. Apologies to the seven people we left in the queue. I'd like to thank everyone for joining today's call. Fortinet will be attending investor conferences hosted by JPMorgan Chase & Co. and Bank of America during the second quarter. Fireside chat links will be posted on the events and presentations section of the Fortinet Investor Relations website. If you have any questions, please feel free to contact me. Have a great rest of your day. Thank you.
Operator (participant)
Thank you for your participation in today's conference. This does conclude the program. You may now disconnect.