Fortinet - Q2 2024

Transcript

Operator (participant)

Good day, and thank you for standing by. Welcome to the Fortinet second quarter earnings 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 11 on your telephone, and you will then hear an automated message advising your hand is raised. To withdraw your question, please press star 11 again. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your first speaker today, Aaron Ovadia, Director of Investor Relations. Aaron?

Aaron Ovadia (Senior Director, Investor Relations)

Thank you, and good afternoon, everyone. This is Aaron Ovadia, Director of Investor Relations at Fortinet. I am pleased to welcome everyone to our call to discuss Fortinet's financial results for the second quarter of 2024. Joining me on today's call are Ken Xie, Fortinet's founder, chairman, and CEO, Keith Jensen, our CFO, and John Whittle, our COO. This is a live call that will be available for replay via webcast on our Investor Relations website. Ken will begin our call today by providing a high-level perspective on our business. Keith will then review our financial and operating results for the second quarter of 2024 before providing guidance for the third quarter of 2024 and updating the full year. We will then open the call for questions. 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.

Before we begin, I'd like to remind everyone that is on today's call that we will be making forward-looking statements. And these forward-looking statements are subject to risks and uncertainties, which could cause actual results to differ materially from those projected. Please refer to our SEC filings, in particular the risk factors, and 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 stated otherwise. Our GAAP results and GAAP to non-GAAP reconciliations are located in our earnings press release and the presentation accompanying today's remarks, both of which are posted on our Investor Relations website.

The prepared remarks for today's earnings call will be posted on the quarterly earnings section of our Investor Relations website immediately following today's call. Lastly, all references to growth are on a year-over-year basis unless noted otherwise. I will now turn the call over to Ken.

Ken Xie (CEO)

Okay, thank you, Aaron, and thank you to everyone for joining our call. We are pleased with our strong execution in the second quarter as we successfully balanced growth and profitability. We achieved record operating margin, which increased 820 basis points to 35%, and managed to achieve billings at the high end of the guidance range. We reached our full-year 2024 revenue and operating margin guidance, and we continue to invest for growth, gaining market share Secure Networking and investing in fast-growing Unified SASE and Secure Operations Secure Networking customers are increasingly recognizing the OS and the ASIC technology, offering 5-10x better performance than our competitors, while improving security effectiveness and providing a low total cost of ownership.

For over 20 years, we have been leading the shift to networking and security convergence, and the industry projection now Secure Networking will surpass traditional network by 2026, 4 years earlier than previously anticipated. In the second quarter, Unified SASE accounted for 23% of total billings, up 1 point. We expect our differentiated Unified SASE offering to become the leader in the SASE market. We believe we are the only company that has built all the SASE functions organically in a single operating system. We have a converged networking and security stack, including our market-leading SD-WAN, ZTNA, Secure Web Gateway, CASB, firewall, and many other innovations. Our strategy offering provides flexible enforcement, delivering a better user experience while securing access to applications on-premises and in the cloud.

Furthermore, we continue to build our own SASE delivery infrastructure, including leverage of FortiOS technologies, providing us with a competitive long-term cost advantage. As announced earlier today, we acquired Next DLP, a next-generation cloud-native SaaS data protection platform extending from endpoint to cloud. This will allow us to enter the standalone enterprise DLP market as well as integrate it with our FortiSASE solution. We also recently improved our position in the Gartner Magic Quadrant for Single-Vendor SASE and are the only vendor included in all five of our major network security Magic Quadrants: Single-Vendor SASE, Network Firewalls, SD-WAN, Security Service Edge, and Enterprise Wired and Wireless LAN Infrastructure. Each of these solutions runs on our single unified operating system FortiOS, with AI-powered FortiGuard security services and unified management. AI-driven SecOps accounted for 10% of total billings in the second quarter, up one point.

Our comprehensive SecOps portfolio, backed by over a decade of AI experience, offers a broader range of sensors and advanced analytics to continuously access activity to identify signs of cyber threats. FortiAI harnesses generative AI to turbocharge our platform and helps security operations teams make better-informed decisions and respond to threats faster by simplifying the most complex tasks. FortiAI is available in FortiAnalyzer, FortiSIEM, and FortiSOAR, and will soon be available in other Fortinet products. In addition, we are pleased to further expand our SecOps portfolio with the acquisition of Lacework, and we believe that together our solutions form one of the most comprehensive CASB cloud security solutions available from a single vendor. Lacework's organically developed AI-driven cloud-native application protection platform will be combined with the power of Fortinet's Security Fabric platform, ensuring broad protection across network, cloud, and endpoint.

This acquisition increased our total addressable market by $10 billion and added a team of talented engineers dedicated to cloud-native security, while also expanding our sales force that can sell the entire Fortinet portfolio of solutions. Yesterday, we announced several enhancements to Fortinet's OT security platform, which already stands as the most comprehensive OT security platform on the market. Enhancements include new ruggedized appliances, Secure Networking and Secure Operations capability, and expanded partnerships with leading OT vendors, reflecting Fortinet's commitment to security for the growing cyber-physical system market. As further evidence of our innovation and commitment to excellence in OT, we recently earned prestigious Red Dot Design Award for a FortiGate Rugged 70G with 5G modem. Fortinet was the only sector security company to achieve this recognition in the Industrial Next-Generation Firewall.

Before turning the call over to Keith, I wish to thank our employees, customers, partners, and suppliers worldwide for their continued support and hard work.

Keith Jensen (CFO)

Thank you, Ken, and thank you, Aaron. And good afternoon, everyone. Let's start with the key highlights from the second quarter. Overall, we are very pleased with our execution in the quarter. We achieved record growth and operating margins at 81.5% and 35.1%, respectively, while delivering top-line numbers at the high end of our guidance range. Revenue grew 11% as product revenue exceeded our expectations, driven by robust software revenue growth and sequential hardware growth that more closely aligned with historical norms. We also added 6,300 new logos as we continue to invest in our channel partners. As you'll hear in a moment, we believe we are on a pace for another Rule of 40 year. At the same time, we accelerated our investments in the fast-growing Unified SASE and security operation markets with the acquisitions of Lacework and Next DLP.

Lacework strengthens our position in the high-growth CNAPP market and expands our total addressable market by $10 billion, while Next DLP improves our position in the standalone enterprise data loss prevention market. Combined, Fortinet will gain over 900 customers and talented sales and engineering teams. And I'll just pause here to offer a very warm welcome to ten members from both companies. Continuing with our Q2 highlights, we have taken the lead in partnering with the U.S. Cybersecurity and Infrastructure Security Agency, or CISA, through a Secure by Design Pledge and are leading with our responsible transparency practices. We want to emphasize we understand customer trust is paramount to our business. Our continued success across all customer segments in each of our three pillars represents hundreds of thousands of end customers testing and buying Fortinet security solutions.

Simply stated, this is a significant scale advantage and a responsibility few others have, and also offers customers validation at a very robust level. We are committed to responsible updates and deployment processes, supply chain controls, product security measures, and transparency. To understand more about the proactive measures we take to safeguard our customers and our reputation, please visit our trust website at fortinet.com/trust. Looking at billings in more detail, total billings were consistent year-over-year at $1.54 billion, overcoming the headwind from the drawdown and backlog in the comparable quarter. At the same time, total bookings increased year-over-year, and more importantly, the sequential growth rate approached pre-COVID pre-supply chain norms. Unified SASE and SecOps delivered strong growth along with software, while product sales recovered more than expected.

We continue to see significant progress from our investments in both pillars and saw strong pipeline growth of 45% for Unified SASE and 18% for SecOps. Both pillars are gaining significant momentum within our install base as over 90% of Unified SASE and SecOps billings are coming from existing customers. Larger enterprises continue to be our largest customer segment, with large and mid-enterprises combining to represent 86% and 82% of Unified SASE and SecOps solutions, respectively. Within Unified SASE, FortiSASE billings continue to grow at triple-digit rates as existing customers can seamlessly integrate our solution within minutes to secure their hybrid workforce, while FortiClient customers are able to use a single agent to secure internet, private, and SaaS applications. We've also integrated FortiAP with FortiSASE for securing thin edges and unmanaged devices. Our Unified SASE solution continues to gain market recognition.

For the second consecutive year, we've been recognized as a challenger in the Gartner Magic Quadrant for Single-Vendor SASE, with the third highest placement in the Ability to Execute axis. As mentioned earlier, we are further improving our FortiSASE solution by adding powerful data loss prevention capabilities from Next DLP. Rounding out the billings commentary, SMB was again the top-performing customer segment, while International Emerging was again our best-performing geography. On an industry vertical basis, technology and transportation grew at double-digit rates, while service provider and manufacturing were more challenged. Turning to revenue and margins, total revenue grew 11% to $1.434 billion, driven by service revenue growth and software licenses. Service revenue of $982 million grew 20%, accounting for 68.5% of total revenue. Service revenue growth was led by 36% growth in SecOps and 27% growth in Unified SASE.

As noted on slide five, Unified SASE includes SSE and related technologies together with SD-WAN. Product revenue decreased 4%, but better than expected to $452 million. Excluding the impact of backlog, product sales growth improved 14 points quarter-over-quarter and a similar amount year-over-year. Software license revenue growth continued to accelerate at 26% and represented a high teens percentage of product revenue, a nearly five-point increase in the software mix year-over-year. Combined revenue from software licenses and software services such as cloud and SaaS security solutions increased 32%, accelerating from 23% a year ago and providing an annual revenue run rate of over $800 million.

Total gross margin increased 360 basis points to a quarterly record of 81.5% and exceeded the high end of our guidance range by 400 basis points, benefiting from higher product and services gross margin, as well as a five-point mix shift to higher margin service revenues. Product gross margin of 66% increased 250 basis points year-over-year, mainly due to increased software mix and lower indirect costs. On a quarter-over-quarter basis, product gross margin increased from 56% to 66% as hardware demand increased and inventory levels and related inventory charges moved closer to historical norms. Service gross margin of 88.6% increased 240 basis points as service revenue growth outpaced labor cost increases and benefited from the mix shift towards higher margin FortiGuard security subscription services.

Operating margin increased 820 basis points to a quarterly record of 35.1% and was 840 basis points above the high end of our guidance range, reflecting the record gross margin as well as cost efficiencies within the business. Looking at the statement of cash flows summarized on slides 16 and 17, free cash flow was $319 million for the quarter and $927 million for the first half of 2024, or $1.1 billion after adjusting for real estate and infrastructure investments. Cash taxes in the quarter were $252 million. As a reminder, last year's second quarter benefited from the deferral of approximately $190 million in cash tax payments, which were ultimately paid in the fourth quarter of 2023. Infrastructure investments totaled $23 million. Average contract term in the second quarter was 28 months, flat year-over-year, and up one month quarter-over-quarter.

DSO decreased 7 days year-over-year and increased 2 days quarter-over-quarter to 68 days. While we did not repurchase shares in Q2, share buybacks have totaled $5.3 billion over the last 4+ years, and the remaining buyback authorization is $1 billion. Now I'd like to share a few significant wins from the second quarter. In a seven-figure deal, an international government agency purchased 12 solutions across all three pillars, including 8 SecOps solutions. This new customer selected Fortinet because of our operating system's ability to consolidate over 30 networking and security functions into a single unified platform covering SecOps, SASE, Secure Networking. the customer was impressed with the integrated security, end-to-end visibility, and automated response features of our FortiOS operating system.

Next, in a seven-figure win, a large utility company expanded our partnership by signing their first enterprise agreement with us to safeguard their OT environment. This deal displaces five legacy vendors and includes ruggedized equipment deployed to the customer's power plants, control centers, and substations. Keys to this expansion win were our proven expertise in securing critical infrastructure and our price or performance advantage. Lastly, in a competitive displacement win, our retail store chain purchased our FortiSASE solution in a seven-figure deal. This customer chose Fortinet because of our integrated FortiOS platform, as they were able to seamlessly integrate FortiSASE with their existing Fortinet security solutions. Now I'd like to offer some comments on customer inventory digestion and the firewall refresh cycle.

Last quarter, we pointed to a 25% improvement in the number of days of registered FortiGate contracts from its peak and viewed this as an early but soft indicator that "inventory digestion" at end users appeared to be normalizing and the firewall market could start to show signs of recovery. To provide an update on this indicator and other signs of possible improvement in the firewall market, we can share that, as shown on slide 19 in the second quarter, the days of registered security service contracts improved another 12 days and has now returned to 2020 pre-supply chain pre-COVID crisis levels. Inventory commitments and levels are normalizing at our contract manufacturers and in the channel. As noted earlier, the sequential increase in hardware sales in the second quarter aligned more closely with historical norms.

While these indicators are positive, we believe customers are currently managing a tough macro environment in a key election year in the U.S., and we believe this is having an impact on our customers' purchasing decisions. As a result, we believe a full refresh cycle is unlikely to occur in 2024, but more likely in 2025. Moving on to guidance, as a reminder, our third quarter and full year outlook, which are summarized on slides 21 and 22, is subject to the disclaimers regarding forward-looking information that Aaron provided at the beginning of the call. Before reviewing the outlook, I'd like to offer a few modeling notes in light of our Lacework and Next DLP acquisitions, covering estimates included in our Q3 and full year guidance. For billings, the acquisitions increased Q3 by approximately 0.5 point and the full year by approximately 1/3 point.

Total revenue increased Q3 and full-year growth by 1 point and 0.5 point, respectively. For gross margin, they decreased Q3 and full-year margins by less than 0.5 of a point for each period. For operating margin, they decreased Q3 and full-year margins by 3 points and 1.5 points, respectively. Inclusive of these acquisition-related estimates, for the third quarter, we expect billings in the range of $1,530 million-$1,600 million, which at a midpoint represents growth of 5%. Revenue in the range of $1,445 million-$1,505 million, which at a midpoint represents growth of 10.5%. Non-GAAP gross margin of 79%-80%. Non-GAAP operating margin of 30.5%-31.5%. Non-GAAP earnings per share of $0.56-$0.58, which assumes a share count of between 767 and 777 million.

Capital expenditures of $40-$60 million, a non-GAAP tax rate of 17%, and cash taxes of $125-$145 million. And again, for the full year, inclusive of the numbers we gave a moment ago, we expect billings in the range of $6,400 million-$6,600 million. Revenue in the range of $5,800 million-$5,900 million, which at a midpoint represents growth of 10%. Service revenue in the range of $3,975 million-$4,025 million, which at a midpoint represents growth of 18%. Non-GAAP gross margin of 79%-80%. Non-GAAP operating margin of 30%-31.5%. Non-GAAP earnings per share of $2.13-$2.19, which assumes a share count of between 767-777 million. Capital expenditures of $320-$360 million. Non-GAAP tax rate of 17%, and cash taxes of between $525 million and $575 million.

I look forward to updating you on our progress in coming quarters. Before we begin the Q&A session, it is with deep sadness that we recognize the passing of our friend Peter Salkowski, our SVP of Finance and Investor Relations. Peter was an integral part of the Fortinet team for over six years and was renowned for his passion for mentoring and developing the next generation of leaders. We'll miss Peter and fondly remember his commitment to fostering talent and nurturing potential within our company. I know that Peter worked closely with many of you on this call, and the outpouring of condolences and heartfelt memories you've shared since his passing clearly shows the positive impact he has had on so many people's lives.

Peter took great pride in his contribution to Fortinet, and rightly so, having contributed to increasing shareholder value from $8 billion to $46 billion during his tenure at Fortinet. We'll miss Peter. Aaron, back to you. Thank you, Keith. 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. Operator, please open the line for questions. Thank you. At this time, we will conduct the question-and-answer session. As a reminder, to ask a question, you will need to press star 11 on your telephone and wait for your name to be announced. To withdraw your question, please press star 11 again. Please stand by while we compile the Q&A roster. Our first question comes from the line of Brian Essex of JP Morgan. Your line is now open. Good evening.

Thank you very much for taking the question. And obviously, sorry for your loss. Keith, if I could maybe touch on the margins, I think it's incredible margin results for the quarter. Could you help me understand or maybe unpack, outside of obviously the gross margin benefit that you saw in the quarter, maybe help me understand where you saw better cost efficiencies, how sustainable are they, particularly in light of the effort to incentivize the channel and the sales force to focus more on selling SecOps and SASE with maybe some incremental effort? Yeah, I think the gross margin is the largest driver of what you saw in the operating margin, particularly when you look at it on a quarter-over-quarter basis.

In that, we talked about or made reference to a more normalized environment for us in terms of inventory levels, turns, and what we're seeing with channel inventory, but also commitments to our contract manufacturers. I think that we've been working through that for probably the last three quarters, maybe four quarters. With that, I would say I think we've returned to a more normal state, and so I would expect that to continue on. I think we're getting a little more contribution from sales and marketing than maybe I'd like at the moment, and I would expect us to make a little bit more investments there as we look through the second half of the year. Keep in mind, we're getting a very large group of salespeople, as Ken made reference to, from both the Lacework and the Next DLP acquisitions.

But I think we feel certainly comfortable with the guidance that we've given for both Q3 and for the full year on the margin line. Great. Maybe just a quick follow-up. How should we anticipate the impact of the operating margin to reflect on free cash flow as we look through the rest of the year? Should we look at historical spread between margin and cash flow margin and maybe estimate kind of ballpark the same kind of spread, or are there going to be more puts and takes, like timing of past payments that are going to mess with that free cash flow margin as we fine-tune our models? Thanks. Yeah, I mean, I think it's a good starting point to look at the improvement in operating margin flowing through to free cash flow.

Some of the changes that we monitor would be things like contract duration, but you've seen now that industries and companies have been talking about contract duration for several quarters, and you really haven't seen that come through to us yet. I shouldn't say yet. I haven't really seen it come through to us. And so I'm not, I think we have opportunity to leverage our balance sheet more with our customers and prospects than we have, but I don't see over the next 90 days or the 180 days a dramatic shift in that area. Okay. Thank you very much. I appreciate it. Thank you. One moment for our next question. Our next question comes from the line of Hamza Fodderwala of Morgan Stanley. Your line is now open. Good evening. Thank you for taking my question, and I'll echo my condolences for Peter and his family.

We'll definitely miss him. Keith, I wanted to follow up on the margin question because obviously it was a very strong beat, I think a lot more than any of us were expecting. Historically, Fortinet has kind of managed the business towards this 25%+ type operating margin run rate. I'm curious, is this the new base that we should sort of think Fortinet goes off of longer term, or is it sort of a one-time margin outperformance given what you saw on the gross margin side coming out of the inventory digestion headwinds? Thank you. Yeah, again, I think the inventory part of that is that I think we've worked our way back to a more normalized state. So I think that is our business model going forward, put it that way.

There can always be something that changes, but I don't see us anticipating something in the gross margin line, and that is by far and away the biggest opportunity there. I think it also says that we clearly have the opportunity to invest more in go-to-market than we did in the first half of this year. I think we've factored in some of that investment ideas or those ideas in our forecast and our guidance. In terms of whether or not I make Ken cry when I increase the margin the way I did, that's a different topic, and I'll let him respond to that. Also, we're benefiting from the service revenue, which has a much higher margin compared to the product revenue. Once the product started growing, because product has a lower gross margin, that's probably what impacted the margin.

But the product is also the lead indicator of future service. So that's where we kind of also be happy to see the product starting also starting growing now, which I think going forward with the product has a higher percentage. That's probably also what impacts the margin. Makes sense. Thank you. Thank you. Thank you. One moment for our next question. Our next question comes from the line of Fatima Boolani of Citi. Your line is now open. Thank you for taking my questions, and I wanted to share my condolences for Peter. He was just a fantastic person, and he will absolutely be missed. Keith, I wanted to zero in on your comments regarding software license growth. You talked about that accelerating 26% year-over-year, I believe, and now it constitutes a high-teens percentage of your product revenues.

I wanted to understand what are the drivers behind that massive mix shift and how we should think about the trajectory of this mix shift in the context of your guidance for the remainder of the year and bringing into consideration some of the hardware digestion potential prolonging comments that you shared as well. If you can help us square that away, thanks. Yeah, I think the software license, if you kind of step back and look at what the business model is, not to make it overly simplistic, we want to, it's so compelling to start with a firewall, and it's very compelling to start with the ASIC, so a physical part of it. We don't always do that, but we almost always start with a firewall, whether it's physical or virtual.

Really, what you want to do is get the operating system in the hands of the customer, and what form factor that takes is we're fairly agnostic about that. But once that happens, then you start to see the knock-on effect of either selling more firewall use cases and other form factors into organizations, or you're seeing that full portfolio of the SecOps product line take hold as it continues to expand throughout organizations. So I would expect that we're going to continue to see tailwinds and growth, no doubt about it, from the software part of the business. Will there be a mix shift that slows a little bit when firewall and FortiGate starts to return? Sure, absolutely.

But this has been a trend that we talked about a little bit, I think, last quarter and probably some earlier quarters about the software mix and the mix shift that we've been seeing. So I would expect that that's going to continue on given the success we're seeing in the other two pillars. Yeah, in the FortiGate, FortiOS, we see customers starting to turn on more and more functions, which also enable more service for us. At the same time, the FortiSASE, SecOps has also. FortiSASE is pretty much our service base and plus a lot of SecOps. SecOps has a high percentage in the software compared with hardware on Secure Networking part. So that's both helping drive the additional software and maintenance growth. Thank you very much. Very clear. Thank you. One moment for our next question.

Our next question comes from the line of Gabriela Borges of Goldman Sachs. Your line is now open. Good afternoon. Thanks for taking the question. I have a for Ken or for Keith. On the firewall refresh cycle, I can appreciate your comments on not expecting to see a recovery in 2024. Share with us a little bit more detail on why you think we'll see it in 2025. To what extent are customers giving you an indication that they will be refreshing in 2025, perhaps as we get through the election and some of the macro, or perhaps because of their updated depreciation plans? Any color on why you think the timing will be 2025 would be helpful? Thank you. I think it's probably more Keith's comment.

I think the rest of the year probably still pretty tough macro-environment, whether election or some interest rates still pretty high, demand costs still pretty high. That's where some companies may not really want to spend some long-term investment, which is drive the product revenue and build infrastructure. So that's what we see. Also, if you look at historically, every 4 years or 4-5 years, the network gear, whether network, network security, they need to be refreshed for faster, more function there. So that's where we feel when we're starting this supply chain issue, they artificially push up the demand like starting 2001. Maybe next year will be pretty much a 4-year cycle now. So some companies may start looking to refresh the product they purchased 4 or 5 years ago, especially in certain verticals like retail and moderate.

We see pretty strong growth in early days of a supply chain issue, and we feel probably in the next 1 to 2 years, they may start to return to see some investment on their infrastructure. On the other side, we see that the big trend we always believe always a hybrid mode. Even there's a we have a very advanced SASE infrastructure side, but also to secure OT, IoT area to secure a lot of infrastructure for home. And we do need appliance in the field. And also, even for SASE, we do offer both cloud-based SASE and also on-premise-based private SASE. So that also needs some hardware to support locally for the customer. Thank you. And our condolences to the team as well. Thank you. Thank you. One moment for our next question. Our next question comes from the line of Tal Liani of Bank of America.

Your line is now open. Hi, guys. The fact that—can you go back to the fact that billings, you made two acquisitions this quarter. You didn't change the billing guidance for the year, but you did beat the numbers for this quarter by $20 million. So in effect, you reduced the billing for the next two quarters. What are the drivers in billings? I know we spoke about it in the past, but what are the drivers for billings, and what's the outlook for billings going forward? Second question is—you grew revenues by 11%, but when you look at OpEx, they're flat. And you don't do buybacks now. What's the outlook for buybacks, and what's the outlook for OpEx? Will it start growing now that you started executing on revenue growth? Thanks. Yeah.

Tal, I think I kind of missed you were very, very faint on your questions there. Maybe if you can give us maybe a little louder recap of the two questions you had. I think I touched some part about the two acquisitions' impact on billings. I believe that those acquisitions, I think it's Lacework, maybe this year will continue maybe at the 20. Yeah, I think that, I mean, if you kind of look at the recap of the year, there's not a lot of variability in it, if you will. We were a little bit light in the first quarter. We came back and recovered the first quarter shortage in the second quarter.

Now you see us looking at the third quarter and maybe taking that just a little bit off of some of the street numbers and looking to see getting a little bit of that back on the fourth quarter. But we're kind of taking the third quarter correction to the street numbers and putting it into the full year number. But yes, offsetting a very, very similar amount in terms of what we expect to get from the acquisitions. And that leaves the full year range very much intact. And I understand that to cut to the quick, I understand part of that is I'm getting inorganic benefit in that number of the 0.5 point that we talked about and really taking down the organic part of the business. But again, I think we're talking about small numbers here. Got it.

My second question, if you can hear me okay now, but my second question was about OpEx that was flat and no buybacks. What's the outlook on those items? Yeah, I think the OpEx is probably a little lighter on the sales and marketing line than maybe we would like to see, particularly if we start looking at more opportunities as we get into the second half of the year and into 2025. So hopefully we'll find some opportunities there to make investments. Obviously, you're going to get a fairly significant movement there from the two acquisitions that we just did, and we gave the number about what the OpEx impact was going to be that will largely be in sales and marketing. Buyback, I think that we still remain being opportunistic, and that opportunistic number changes every 90 days as we reset our plans. Yeah.

Also in the market, whether the private company, public company, we see the multiple probably more friendly for multiple issues now compared to the last two, three years. So we should go back to more reasonable. So that's where we see some opportunity there. Great. Thank you. Thank you. One moment for our next question. Our next question comes from the line of Rob Owens of Piper Sandler. Your line is now open. Yeah, thank you guys for taking my question. Curious relative to the macro and obviously a lot of cross currents out there, maybe what you're seeing via your different customer sizes and different theaters. Thanks. Yeah, I think because we are so diversified, as you kind of alluded to it, 70% of the business is international and a little bit less than 30% in the US.

Yes, there's been a lot of elections around the world this year, but it's certainly the US election maybe weighing on people and everyone's kind of taking a position of waiting to see. As you move, pull back from that, the International Emerging part of the business has been strong, very strong for several quarters and continues on to be so. A lot of those are oil-producing countries and similar. So I think they've done well in this economic cycle. They're a little more risk there perhaps with geopolitical events in some of those countries, but to this point, it really hasn't had an impact there. We are much more likely to have the number one market share when you move outside the US and in parts of Europe and the Middle East and Latin America and in parts of APAC.

And I think having an incumbency advantage, if you will, helps you in those more challenging times because you're there, you're on site, and you have that opportunity to cross-sell and upsell your install base. Yeah, in the U.S., that's the next growing area, which also needs more direct marketing, direct sales. That's also needs more investment. So that's what we do plan to invest more into sales marketing to gain a market share in the U.S. And Keith, as you contemplate these acquisitions and a little bit of mix shift to software, and I realize hardware is weak right now with potential recovery next year, but how are you thinking about billing's duration? You shave some off the back half, and I think some of that's probably the mix shift towards software as we kind of look overall at the model and the increase in revenue.

But as we contemplate 2025, how should we think about billing's duration and potential compression with more cloud-based or software deals that are likely shorter in nature? Yeah, well, I look forward to seeing you in November, in November at the Analyst Day, when we'll talk more about 2025 and midterm numbers. But in the interim, I would probably say that if it's a white space account in some of these places, like Lacework would be, for example, I think it's going to be much more prone to having a shorter duration contract. If it's part of that 90% of me selling SecOps or SASE solutions to my install base, what I'm seeing to this point is my install base continues to purchase in terms of contract duration the way they have historically.

So they haven't if I sell something from the SecOp portfolio into one of my firewall customers, they tend to sign up for a longer duration contract than you may see from a point solution vendor. Great. Thanks. Thoughts are with you and the team. Thank you. Thank you. One moment for our next question. Our next question comes from the line of Shaul Eyal of TD Cowen. Your line is now open. Thank you. Hi, good afternoon, everybody. Keith or Ken, so listening to Keith's commentary about the potential refresh cycle not taking place in the second half of this year, but most likely during 2025. And again, not trying to front-run the November Analyst Day, but should we be thinking about 2025 accelerating over 2024?

And again, I know you don't have the current visibility to guide to 2025, but just conceptually, is it fair to assume another year of double-digit growth? We do believe next year there's a, I think, first overall, we see the long-term convergence, networking convergence to network security will still keep on going. And that's why we do give the CAGR Secure Networking areas about 15% year-over-year growth. If you look in the investor presentation slide there, I forgot which page. But on the other side, we also see a lot of new opportunity, whether in the OT area, in the Unified SASE, and also upsell, cross-sell, which all help in driving. I have to say probably like 90% of customers initially more buy FortiGate getting the firewall network security market first, which we have a huge advantage over a competitor.

But after that one, they keep expanding beyond the network security, go to the other area. So that's what's happening for the Unified SASE, for the SecOps. And now the product, especially on the FortiGate firewall side, we're starting to see kind of a go back to normal or starting growing with the market now. So we do feel probably next year will be where the refresh cycle, which after that's where the existing customer, if they have the product for four or five years, that's probably the average term they're starting refresh. And so we do see probably next year we're starting up that process. Got it. Thank you. Thank you. One moment for our next question. Our next question comes from the line of Brad Zelnick of Deutsche Bank. Your line is now open. Great. Thanks so much for taking the question.

Keith, I think you called out the service provider segment is more challenged this quarter after being a strong performer last quarter. I know it's lumpy and remains a top vertical, as it always has been performing it. But can you share an update on what's happening in that segment? And in particular, how your value prop and unified and focus on Unified SASE and SecOps applies in this important vertical? Yeah, I don't feel the service provider telecom slowed down. It's really kind of lumpy. And on the other side, we also started to see the telecom service provider more interest in offering their own SASE using a product solution, all kind of helping customers do the private SASE, localized SASE, which also will help in drive our long-term growth.

But I do believe long-term-wise, the service provider will be still the big, if not the biggest, probably one of the biggest parts of the whole cybersecurity business, because they have the infrastructure, they have the customer relation. So we still want to keep in focus on the service provider area. But for them, it's really the sales cycle is relatively long, and the deal is pretty big, usually like eight-figure deal. That's where the lumpiness probably impacts the quarterly. But if you look at more long-term, multi-quarter, annually, I do believe they're still keeping growing. Yeah, I can spot on, right? It's a lumpy industry. Financial services can be too at times as well. But I think more importantly, I think the conversations around their own independent SASE solution that they can bring to market is something that's getting a lot more conversation from the service providers.

I think we saw it first internationally, and we're starting to see a little bit more of it here domestically. That's a pretty exciting opportunity if it continues to move forward. Thanks, Keith, and thanks, Ken. Just a quick follow-up on the very impressive operating leverage that you've shown us, particularly on the sales and marketing line, where I know, Keith, you said that it's more than you'd like to see at this point. But just structurally, to see it down, albeit very slightly, sequentially on a dollar basis, especially as you outperformed on the top line and billing this quarter, I'm just trying to understand where it comes from, and is there anything structurally that's changed that we should be thinking about, whether it's commission deferral rates, channel rebates, or anything else other than headcount? Thanks. Yeah, I think there's a few things going on there.

I think probably nine months ago, we looked at the cost structure pretty closely across a number of areas. The first place that people kind of look at when you're in that boat is marketing programs, and they get hit pretty hard early on. I think you kind of see that roll through. You do make changes to your compensation programs, whether it's for direct salespeople or for channel people, what have you. I think maybe as we're coming out of that environment now, it's important for us to kind of revisit some of those decisions and making sure they kind of talk about the investment opportunities that we have in the sales and marketing line. I think I would include the channel in that as well.

It's why I would say that, to your point, or you're repeating me, probably a little bit lower than we would have liked it to have been in the second quarter. I think we'll continue to make go-to-market investments here in the second half of the year. Yeah, I agree with Keith. We started tracking more carefully for the ROI for each investment in marketing sales and also try to improve the efficiency with the marketing sales. On the other side, we're a little bit behind on hiring in the sales marketing side, which we intend to accelerate. So that's actually what will drive the future for us. Thanks very much, guys. Thank you. Thank you. One moment for our next question. Our next question comes from the line of Adam Tindle of Raymond James. Your line is now open. Okay, thank you.

I just wanted to continue the margin discussion. Obviously, you had great product gross margin performance this quarter on top of those tight cost controls. And the question really is around pricing dynamics and the core firewall business from here. The supply chain sounds like it's clearly normalized. You've had multiple years of price increases during this period of time. What are your expectations of the pricing dynamic in core firewall from here? What would it take to maybe even consider reducing price back to historical at some point? And any comments that you want to make on the competitive environment in light of this? Thank you. I think we have not increased the price in the last few quarters.

I think that because we still believe we have a huge advantage with our FortiASIC, FortiOS technology as a more functional, better performance, lower total cost ownership, and also energy costs. So we feel we're keeping that advantage over our competitors. On the other side, we don't see any pressure to also decrease price or kind of discount more. So that's where we feel we're keeping pretty stable for the price. And at the same time, let the customers see the benefit of our product solution and with better performance, more function, which also will drive the future service. I think the bigger environment also, we don't feel changed much. Definitely, we see that the inventory all go back to normal, whether own kind of inventory and also the channel inventory. That's also more helping driving the healthy behavior in the business, also in the supply chain area.

Maybe Keith has some. Just to repeat what Ken said, and maybe with a little more granularity, I think the price increases that you referred to were really probably a late 2021, 2022 impact, and I don't think we're really raising prices in 2023. We did take some prices down at the end of 2023 and in the very beginning of 2024, but that's really been the only pricing actions of note we've taken the last six months. And then to Ken's point, I think we're at a moment where we think it's probably the value for the solution is very, very strong.

I think the energy costs that Ken mentioned is starting to get. It's gotten a lot of traction internationally in Europe, but you're starting to see more conversation around that in the US, and that could be people concerned about energy consumption and issues with AI and EV and government actions on manufacturing. So I do think the energy cost advantage is coming into play more. And then the last one on that discounting was, I think, very much in line. I think we actually improved discounting, meaning higher prices, by about a point, quarter over quarter, and kind of a similar number one way or the other for the full year. So we obviously have room, given the margins, to use discounting and pricing as a lever. But I think there's other things that we'd like to push on first. Makes sense. Thank you. Thank you.

One moment for our next question. Our next question comes from the line of Adam Borg of Stifel. Your line is now open. Awesome. Thanks for taking the question. And I'll also offer the condolences on Peter's passing. He certainly missed by all of us. We'd love to talk about the Next DLP acquisition. Maybe talk a little bit more about what's attracting you to the standalone enterprise data protection market overall and Next DLP in particular. Yeah, thanks for the question. This is John Whittle. There's a lot of positivity around that. We obviously just announced it today. We closed it yesterday. We did a lot of diligence on the company. The tech is great. And not only will we plan to offer it standalone, but also integrated with our FortiSASE solution. And so I think it's another step in steadily bolstering our FortiSASE solution.

We feel very, very confident in our strategy there. For the most part, as you know, I mean, we've done some tech and talent tuck-ins. Most of our technology is organic. I think to some of the earlier questions, you think about the firewall market coming back next year. And we really just started kind of organizing our solutions into these three pillars less than a year ago. And the amount of progress we made and the execution we've made in kind of developing very, very competitive solutions in SASE and SecOps in addition Secure Networking is pretty impressive. And I think this is an important step along the way to continue to develop the best SASE solution out there to protect our customers. That's great.

Maybe just as a quick follow-up there, John, maybe just could you comment on current level of the sales force productivity for SASE and SecOps and the opportunities to improve this year? Thanks again. Sorry, the sales execution with SASE and SecOps? Just general sales force productivity as you've gone through many months at this point of training and just ramping of the ability to sell that across your company globally. Yeah, no, it's a really good question. I think what we're seeing is it does take time. We are very focused on that broad sales enablement. I always say, I mean, the opportunity just abounds from our solution set. And we're always with this customer-first focus. So in terms of protecting and serving our customers, the opportunity abounds. I think our sales force, the good news is they have a ton of opportunity.

I always say they're going to suffer more from indigestion than starvation, but we've got a really big focus in the company to really train up that sales force, enable that sales force, make sure we have the incentives in the right place, and make sure we have the support. So when they do qualify different opportunities and other different solution sets, we have the support to support them in that sale. So I think, like Keith had alluded to, we often land with the firewall and then expand and give that support to our sales force with SASE and SecOps solutions. And we're seeing a lot of success there. Great. Thanks again. Thank you. Thank you. One moment for our next question. Our next question comes from the line of Saket Kalia of Barclays. Your line is now open. Okay. Great, guys.

Thanks for taking my questions here and tip my cap to Peter as well. We're going to miss him. Ken, maybe just to start with you, I want to dig into just the firewall refresh for next year a little bit. I mean, you've seen so many refresh cycles over the years. How would you sort of compare this upcoming cycle versus others in the past? And maybe touch on how SASE and sort of maybe what sounds like a higher mix of virtual might sort of play into that. Yeah, agreed. The infrastructure is probably different than the last refresh cycle. You see more hybrid working environment, whether working remotely and also more supporting broad connection, including connect all these OT, IoT device level. For the SASE, we always believe also should be a hybrid SASE environment, not just cloud only.

You do need to have a private SASE, some other local SASE offered by service provider. And also sometimes the SASE also needs to secure some device which cannot install a software agent, like using a FortiAP, FortiSwitch to secure this agent in this device. So that's what we feel. This also will always kind of the Unified SASE will be the long-term future, we believe, which also combines both the hardware and the software and infrastructure and applies together. So that's where the refresh. On the other side, network security is always probably the biggest market. I mean, has been the biggest market in the cybersecurity for probably 30 years now, 20, 30 years. Keeping expanding because more people's devices get connected and more applications to access all these, even access the cloud, you do need to secure on the network side.

So that's what we see when you try to access the network side and also the long-term convergence of networking and network security. That's also what drives the refresh. That's also, you can see the Gartner research we point out, the convergence of networking and network security also starting to accelerating. So originally, I think last year they said by 2030, Secure Networking will be larger than traditional networking. Now they say 2026, four years ahead, Secure Networking will be larger than the traditional networking. So that's where we really invest long-term on this trend. And with all this FortiOS, FortiASIC, kind of making the best both appliance and infrastructure, the ASIC, OS technology, and at the same time also try to invest more in the sales marketing area to really catch the trend and also keeping gaining market share. So that's the strategy behind.

That makes a lot of sense. Keith, if I could fit in one quick follow-up, just on the software mix in product, I think you said call it a roughly $800 million run rate. Can we just touch on, even anecdotally, roughly how much of that is sort of virtual firewall versus SecOps? And I realize they're coming in at software gross margins, but can you put a finer point on that and sort of what that aggregate business might be coming in at from a gross margin perspective as we think about that gross margin shift long-term? Well, I think whether it's a virtual firewall or any other software product, the software licenses are all coming in at very, very attractive margins.

I think that when you look at some of the SaaS solutions that are sitting in the services line for SecOps and so forth, you get a very wide range of margins there, but it's only because of the relative size and maturity of the solution. Obviously, something that's very new and absorbing a lot of the hosting costs is a little harder, but those aren't as big numbers. As you see those SecOps solutions get greater and greater traction and more critical mass, the margins start to normalize. I think kind of what's really been exciting is the ability to absorb those data center, PoP, colo, everybody's got their hand in the pot on these things, cloud provider fees and developing the SaaS solutions and still bring up the services gross margin.

And by the same token, being able to absorb the charge for late work on the operating margin line because we've managed the business in terms of cost of goods sold for the product side, I think we're really, really pleased with how those two things will work hand in hand. Absolutely. That shows. Thanks very much. Thank you. One moment for our next question. Our next question comes from the line of Joseph Gallo of Jefferies. Your line is now open. Hi. Thanks for the question. I also want to echo my condolences to the team and Peter Salkowski that choose to fill. I just wanted to double-click on what drove the better performing product in Q2. Was there some large deals, a region, segment, or vertical that stood out, especially since you don't expect the refresh benefit until calendar 2025? No, great question.

I mean, we've talked about eight-figure deals and at our size, eight-figure deals can kind of still whipsaw around. As you saw in the fourth quarter last year, we did 6 of them. We had one six-figure, eight-figure deal Q1. We had 2 in Q2. So I wouldn't attribute it to that. I think that I think what we saw the last month of the quarter, and particularly as we got into the last week of the quarter, what you see in a strong market is a lot of deals starting to fall in place and we're getting across the finish line. I think we saw a lot more positiveness, if you will, at the end of Q2 than maybe we saw, say, at the end of Q3 or something like that last year. Okay. Thanks.

And then just on a follow-up to that, and I think it was a follow-up to Fatima's question, given that mix shift you now expect in the second half, given the delayed refresh, what is your confidence or visibility into the billings re-acceleration in the second half? Do you, in theory, have more visibility now given that it's less hardware-based? Or how are you thinking about that? Thank you. Yeah, I don't think that the form factor really impacts the visibility in terms of what's in the pipeline or how we work with the sales teams in terms of forecasting. I've not noticed a difference, if you will, in close rates between a virtual machine and a physical machine.

Yeah, we probably would do some more deep study to maybe stabilize some color next year and also some mid-term model in November 18, which also the 15th anniversary of FortiOS. Thank you. Thank you. Thank you. Thank you. This concludes the question and answer session. I would now like to turn it back to Aaron Ovadia, Director of Investor Relations. Thank you. I'd like to thank everyone for joining today's call. Fortinet will be attending investor conferences hosted by Deutsche Bank, Goldman Sachs, and Oppenheimer during the third quarter. We will also be holding an Analyst Day on November 18th, where we expect to update our medium-term financial model. The webcast links will be posted on the event and presentation section of Fortinet's investor relations website. If you have any follow-up questions, please feel free to contact me. Have a great rest of your day.

Thank you for your participation in today's conference. This does conclude the program. You may now disconnect.