Fortinet - Q3 2024
November 7, 2024
Transcript
Operator (participant)
Good day, and thank you for standing by. Welcome to the Fortinet Q3 2024 earnings 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 then hear an automated message advising your hand is raised. To withdraw your question, please 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 your first speaker today, Senior Director of Investor Relations. Please go ahead.
Aaron Ovadia (Senior Director of Investor Relations)
Thank you, and good afternoon, everyone. This is Aaron Ovadia, Senior Director of Investor Relations at Fortinet. I am pleased to welcome everyone to our call to discuss Fortinet's financial results for the third quarter of 2024. Joining me on today's call are Ken Xie, Fortinet's founder, chairman, and CEO, Keith Jensen, our CFO, John Whittle, our COO, and Christiane Ohlgart, our CAO and Sales Operations Leader.
This is a live call that will be available for replay via webcast on our Investor Relations website. Ken will begin our call today by providing a high-level perspective on our business. Keith will then review our financial and operating results for the third quarter of 2024 before providing guidance for the fourth quarter of 2024 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 on today's call, we will be making forward-looking statements, and these forward-looking statements are subject to risks and uncertainties, which could cause actual results to differ materially from those projected.
Please refer to our SEC filings, in particular the risk factors in our most recent Form 10-K and Form 10-Q for more information. All forward-looking statements reflect our opinions only as of the date of this presentation, and we undertake no obligation and specifically disclaim any obligation to update forward-looking statements. Also, all references to financial metrics that we make on today's call are non-GAAP unless otherwise stated.
Our GAAP results and GAAP to non-GAAP reconciliations are located in our earnings press release and in the presentation that accompanied today's remarks, both of which are posted on our Investor Relations website. The prepared remarks for today's earnings call will be posted on the quarterly earnings section of our Investor Relations website following today's call. Lastly, all references to growth are on a year-over-year basis unless otherwise noted. I will now turn the call over to Ken.
Ken Xie (CEO)
Thank you, Aaron, and thank you to everyone for joining our call. We are pleased to report another quarter of strong execution and continued growth momentum, including record gross margin and operating margin, with the operating margin increased by 830 basis points to over 36%. Total revenue growth of 13% as we return to positive billing and product revenue growth.
Unified SaaS billing growth of 14%, secure operations billing growth of 32%, and secure networking return to positive growth, all driven by a continued share gain in our total addressable market of $284 billion. As highlighted on slide 11 of the investor presentation, Fortinet continues to be the only vendor to leverage a single operating system FortiOS., delivering solutions in five Gartner Magic Quadrant reports, secure service edge, SD-WAN, single-vendor SASE, network firewall, and enterprise-wide wireless LAN infrastructure.
FortiOS, combined with the proprietary FortiASIC technology, significantly boosts secure computing power, delivering 5x to 10x better performance than our competitors while lowering customers' total cost of ownership and energy consumption. In the third quarter, Unified SASE billings was 23% of our business, up one and a half points, driven by SSE billings growth of 220%, with pipeline up 130%.
Fortinet is the only vendor offering all SASE functions in a single operating system and providing a unified networking and security stack on-premises and in the cloud. This allowed Fortinet SASE to be deployed within minutes to our SD-WAN customers. Our single OS-based Fortinet SASE also enables Sovereign SASE for service providers and large enterprises to deploy Fortinet SASE with their own data center for data privacy.
In addition, we were recently recognized as a clear leader in the 2024 Gartner Magic Quadrant for SD-WAN for the fifth consecutive year, and notably, our position is the highest of all vendors in ability to execute for the fourth year in a row. Leveraging Fortinet's leading position in firewall and SD-WAN and our integrated Fortinet SASE within the same FortiOS, Fortinet provided the easiest and most secure path for migration from traditional firewall to secure SD-WAN and Unified SASE.
We continue to invest in our global infrastructure, spanning over three million sq ft across office space, executive briefing center, operation facility, and data centers. Our own hosting capability will give us a long-term cost advantage while allowing us to use our own Fortinet stack for better security and management.
AI security operations was our fast-growing pillar, outpacing the overall market with a 32% billings growth, accounting for 10.5% of our total business, up two points. We have expanded our security operations portfolio with the launch of a Lacework FortiCNAPP and FortiDRP, which together represent a new $20 billion market opportunity, and we expect to cross-sell both solutions to a large install base of customers.
Our commitment to innovation and investment in R&D has enabled us to rapidly expand FortiAI, our GenAI system, into seven key solutions: FortiAnalyzer, FortiManager, FortiSIEM, FortiSOAR, FortiDRP, and recently announced FortiNDR and FortiCNAPP.
More GenAI-enabled FortiAI products will be announced in early 2025 as Fortinet's AI-based secure operations business accelerates. Before turning the call over to Keith, I would like to thank our employees, customers, partners, and suppliers worldwide for their continued support and hard work. Keith.
Keith Jensen (CFO)
Thank you, Ken. Thank you, Aaron, and good afternoon, everyone. Let's start with the key highlights from the third quarter. We are very pleased with our strong execution and financial performance in the third quarter, repeating our second quarter performance by again achieving record gross margins and record operating margins while delivering top-line results at the top of our guidance range.
Total revenue grew 13%, driven by strong growth in services revenue and product revenues returned to growth. We again added over 6,000 new logos, driven by the resilience of small enterprise customers and the strength of our robust channel partner ecosystem. As you will hear in a moment, we are pleased to again raise our revenue and operating margin guidance for the full year, and we believe we are on track to achieve our seventh consecutive year of exceeding the Rule of 40.
Looking at billings in more detail, RPO grew 15% to $6.1 billion, and total billings grew 6% to $1.58 billion, driven by robust growth in security operations at 32% and Unified SASE at 14%. SSE and related cloud technologies were again the fastest growers in Unified SASE, benefiting from our large SD-WAN customer base.
Our Unified SASE and security operation pillars are gaining considerable traction, with over 90% of their billings coming from our secure networking installed base and combining to drive our SaaS solution organic ARR growth rate of 74%. The customer buying journey from FortiGate to SD-WAN to SASE supports our customers' drive towards consolidation and is gaining traction. This consolidation journey first begins with a firewall and FortiOS and typically expands to SD-WAN and next to SASE.
I should share that two-thirds of our large and mid-enterprise customers have deployed our SD-WAN technology, providing them with a gateway to Fortinet SASE. Of these large customers, our first year of SASE delivered high mid-single-digit penetration rates, highlighting both the dramatic expansion opportunity as well as customer demand for vendor consolidation.
Including all elements of Unified SASE, pipeline growth was over 30%, and while the SSE technologies are seeing pipeline and ARR growth of 130% and over 500%, respectively. Larger enterprises continue to drive our expansion into Unified SASE and the security operation markets, with large and mid-enterprises representing 91% and 76% of SASE and SecOps billings, respectively.
As we work through the wind-down of last year's backlog and the related year-over-year headwind to growth this year, secure networking has returned to growth as we expected. Rounding out the billings commentary, SMB and large enterprise were our top two performing customer segments, while EMEA was our best-performing geography with double-digit growth. Among our top five verticals, manufacturing billings grew by over 20%, driven by OT billings growth of 19%.
Retail returned to growth for the first time in six quarters, up 9%, while the service provider vertical reached its highest growth rate over that same six-quarter period. Turning to revenue and margins, total revenue grew 13% to $1.508 billion, driven by 19% service revenue growth and product revenues returned to growth. Service revenue of $1.034 billion grew 19%, accounting for 69% of total revenue.
Service revenue growth was driven by growth in our SaaS solutions, including 50% services growth in SecOps and 27% services growth in Unified SASE. Product revenue returned to growth for the first time in five quarters, increasing 2% to $474 million.
Excluding the impact of backlog, product revenue grew sequentially at double-digit rates, outpacing historical norms for Q2 to Q3, and following a similar storyline on what we saw in Q2, when sequential growth also outpaced historical norms. A moment ago, we talked about solution consolidation and described the customer's journey around firewalls to SD-WAN and onto SASE.
A second customer buying journey is supporting customers' convergence of security and networking. Their journey begins with FortiGate firewalls and expands to leverage our FortiLink technology to manage Fortinet switches and access points. It's worth noting that over 95% of our larger enterprise switch customers previously or simultaneously purchased FortiGate firewalls. At the same time, our switch penetration rate for these larger customers is around 50%, highlighting both our success and the future opportunity.
Software license revenue continued its double-digit growth, driven by SecOps solutions and represented a mid to high-teens percentage of total product revenue. Combined revenue from software licenses and software services, such as cloud and SaaS security solutions, increased 33%, accelerating from 32% in the second quarter and providing an annual revenue run rate of over $900 million.
Total gross margin increased 630 basis points to a quarterly record of 83.2% and exceeded the high end of our guidance range by 320 basis points. Gross margins benefited from higher product and service gross margins, as well as a four-point mix shift to higher margin service revenue.
Product gross margin of 71.6% was also a quarterly record and increased 1,370 basis points, which includes a 320 basis point benefit related to the renegotiation of supplier contractual commitments. Excluding this one-time benefit, the product gross margin would have been 68.4%.
Service gross margin of 88.5% increased 130 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 830 basis points to a quarterly record of 36.1% and was 360 basis points above the high end of our guidance range. Excluding the one-time benefit to product gross margins, operating margins would have been 35.1%.
Taken together with our reported Q2 margins, the Q3 margins, excluding the one-time benefit, provide directional insights to our financial performance. Before moving on to the statement of cash flows, I'd like to provide a few details related to the impact of Lacework and Next DLP acquisitions. These acquisitions increased Q3 billings and revenue by approximately 60 and 90 basis points, respectively, and increased gross and operating margins by about 30 and 220 basis points, respectively.
I spoke when I said decreased gross margin and operating margins. Looking at the statement of cash flows summarized on slides 16 and 17, free cash flow was $572 million, representing a margin of 38%. Adjusted for real estate investments, the margins came in at 40%. In the first nine months of the year, free cash flow was $1.5 billion, or $1.75 billion after adjusting for real estate investments.
Cash taxes were $140 million, up $114 million, reflecting the prior year's regulatory extensions of estimated tax payments. Infrastructure investments totaled $36 million. The average contract term in the third quarter was 28 months, flat year-over-year and quarter-over-quarter. DSO decreased 6 days year-over-year and quarter-over-quarter to 62 days, reflecting stronger than usual linearity.
The $106 million gain on bargain purchase from the Lacework acquisition relates to NOL carryforwards and the related recognition of the deferred tax assets. The gain is excluded from our non-GAAP financials, but it is included in the GAAP financials, adding $0.14 per share to our GAAP EPS. Share buybacks in the quarter totaled $600,000, and last month, the board increased the share repurchase authorization by an additional $1 billion, bringing our remaining share repurchase authorization to approximately $2 billion.
Now, I'd like to share a few significant wins from the third quarter. First, in a seven-figure upsell deal, an existing SD-WAN customer in the retail industry continued their consolidation journey, adding Fortinet SASE for 16,000 users. This customer selected our Fortinet SASE solution for its simplicity, ease of management, and consistent security enforcement across their infrastructure.
We outperformed the competition by leveraging our FortiOS operating system, streamlining operations, and reducing cost of ownership, while showcasing our ability to consolidate multiple security functions onto a single platform.
In another seven-figure win, a medical device company purchased Fortinet SASE to replace their existing solution. This customer chose Fortinet for its simplified and consistent security management, significant cost savings, and Fortinet SASE's enhanced functionality, particularly the bidirectional connectivity between their data center and remote users, enabling them to push policies more effectively.
In an eight-figure competitive displacement win, a multinational bank commenced their partnership with us by selecting our FortiGate Firewalls and multiple SecOps solutions to secure their hybrid architecture. This customer was particularly impressed with our integrated security end-to-end visibility and automated response capabilities of our FortiOS operating system. Before discussing our guidance, I'd like to offer a couple of comments on the firewall recovery and refresh opportunity.
During last quarter's remarks, we mentioned that the continued improvement in the days to register FortiGuard contracts indicated the inventory digestion at end users was returning or had returned to normal. In the third quarter, this metric was stable, further validating our view that the firewall market is recovering.
Today, we'd like to add to this commentary by noting that in 2026, a record number of FortiGate will reach the end of their support life cycle, and we expect these customers to start the refresh cycle for these products sometime in 2025. Moving on to guidance, as a reminder, our fourth quarter and full year outlook, which are summarized on slides 19 and 20, are subject to the disclaimers regarding forward-looking information that Aaron provided at the beginning of the call.
Before reviewing our outlook, I should note we expect Lacework and Next DLP, or those acquisitions, to increase Q4 billings and revenue by 75 and 135 basis points, respectively, and decrease operating margins by 230 basis points. All right. For the fourth quarter, we expect billings between $1.9 billion and $2 billion, which at the midpoint represents growth of 5%.
Revenue in the range of $1,560 million-$1,620 million, which at the midpoint represents growth of 12%. Non-GAAP gross margin is 79.5%-80.5%. Non-GAAP operating margins of 33%-34%. Non-GAAP earnings per share are $0.58-$0.62, which assumes a share count of between 768 million and 778 million. Capital expenditures of $100 million-$120 million, a non-GAAP tax rate of 17%, and cash taxes of $127 million-$177 million. For the full year, we expect billings in the range of $6,430 million-$6,530 million.
Revenue in the range of $5,856 million-$5,916 million, which at the midpoint represents growth of 11%. Service revenue in the range of $4,015 million-$4,045 million, which at the midpoint represents growth of 19%. Non-GAAP gross margin of 80.3%-81.3%. Non-GAAP operating margin of 32.9%-33.9%. Non-GAAP earnings per share of $2.20-$2.28, which assumes a share count of between 766 and 776 million.
Capital expenditures of $380 million-$400 million. Non-GAAP tax rate of 17% and cash taxes of between $550 million and $600 million. I look forward to seeing you at the analyst day later this month and updating you on our progress in the coming quarters. I'll now hand it back to Aaron to begin the Q&A session.
Aaron Ovadia (Senior Director of Investor Relations)
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.
Operator (participant)
Thank you. At this time, we'll conduct a question-and-answer session. As a reminder, to ask a question, please press star one one on your telephone and wait for your name to be announced. To withdraw your question, you may also press star one one again. Please stand by. Please stand by while we load our first question. Our first question comes from Hamza Fodderwala with Morgan Stanley. Your line is now open.
Hamza Fodderwala (Executive Director of US Software Equity Research)
Great. Good afternoon. Thank you for taking my question. Ken, I couldn't help noticing in your investor presentation, you talked about a market growth that you see over $200 billion growing 12% over our next four years. Obviously, a big chunk of that growth is driven by the SASE market and your share gain there.
I'm curious if you could talk a little bit more about Fortinet's approach in terms of Sovereign SASE. How is that differentiated versus some of the competitors out there, and what is it that you're doing differently, particularly for those highly regulated verticals out there? Thank you.
Ken Xie (CEO)
Yes. Thank you, Hamza. It's a great question. We invest in the SASE for 5-10 years in the market, including all the SD-WAN and also all the SASE functions in the same FortiOS, both on-premise, also in the cloud. So there's a huge differentiation with other competitors, which they cannot run the SASE, whether in the same OS or even different box and that's for the Sovereign SASE. We usually call private SASE.
Actually, if you look at probably one year ago, we were more focused in that area with a lot of service providers, which is quite important for them to deploy the SASE in their own data center to process data and also to keep the data in their own kind of data center and also process also within their own data center. So that's a two important factor there.
So they have to be local to secure the data and, at the same time, to process data locally. So that's a huge advantage in the same OS and also a lot of functions can use in FortiASIC or SASE. The other differentiation comes from the business side. So we have a number one on the network security firewall. We are also the number one on the SD-WAN. So leverage our installed base and also both the firewall function and also SD-WAN function in the same OS with the SASE.
So that's for the customer. They have the most easy migration path from the traditional firewall vendor, I mean, from the traditional firewall customer to the SD-WAN customer, go to SASE. It's only a few minutes reconfiguration. They can enable SASE based on their previous SD-WAN or the firewall configuration there. So it's a very easy migration path.
As you can see, the pipeline grows and also the business growing there from SSE, like over 200%. The pipeline grew over 100%. So we do believe we'll be the number one leader in the SASE space in the next few years.
Hamza Fodderwala (Executive Director of US Software Equity Research)
All right. Thank you.
Ken Xie (CEO)
Thank you.
Operator (participant)
Thank you. Our next question comes from Brian Essex from JPMorgan. Your line is now open.
Brian Essex (Executive Director and U.S. Software Equity Research Analyst)
Hi. Good afternoon. Thank you for taking the question. Stick to one topic. I guess either Ken or Keith, could you dig into the commentary around the firewall refresh cycle that you provided? So with respect to conversations you're having with customers and maybe with a little bit of color of what you've seen historically, how far before the renewal point do customers tend to refresh?
Do you have any insight into the mix of SMB, large enterprise, service provider, retail, and what the timing and the magnitude might be, whether this might be a first-half event, second-half event, any kind of insight you could provide would really be helpful.
Keith Jensen (CFO)
Yeah. I'll kind of jump in a little bit on this. I think that we see these end-of-life of these products starting in the second half of 2026. We don't expect the customers to wait till the 11th hour to make the change. For larger enterprises, they would go through another certification, POC project, perhaps as part of that before they place them in service. So we saw a similar—not similar.
We saw a lift, if you will, similarly in 2023, although the magnitude in 2026 is much, much larger and why it's relevant to 2023 is that if you go back and look at product revenue growth in 2022, very different world, supply chain, switches, etc. But I think in 2022, the product revenue growth was a little bit over 40%. So we do think there's a relationship there. We do think it starts earlier.
To the second part of your comment, as I mentioned, the absolute number that we see in 2026 is by far the largest we've seen probably ever, but certainly in the last five or six years. Each year, it's dominated by the entry-level firewalls.
However, in 2026, we do see a significant portion of that actually being in the mid-range firewalls as well and that is a very unusual and positive situation. I don't have a breakdown by SMB or something else. Maybe Christiane wants to offer something more on that.
Brian Essex (Executive Director and U.S. Software Equity Research Analyst)
Or by vertical. I think you've mentioned before that you need large enterprise, retail, and service provider in order to recover. So if you have any insight there and how their cycles and spending patterns may impact that, that would be helpful.
Keith Jensen (CFO)
Well, again, I think 2022 was a robust year for those industries that you just talked about, retail in particular, and pretty much manufacturing across the board. And I would expect that they would be active players, if you will, in the refresh cycle that we see in 2026. But Christiane?
Christiane Ohlgart (Chief Accounting Officer)
Yeah. You were asking whether or how early customers would refresh and many of the enterprise customers have enterprise agreements where they have account-level support and subscriptions. So they don't really wait until something expires.
They will probably. I would expect what we typically see refresh about a year before EOS. For smaller customers, they will probably try to wait until the contracts expire. But because we don't allow them to renew for less than a year, you also see these refresh cycles happening about 15 to 18 months out.
Brian Essex (Executive Director and U.S. Software Equity Research Analyst)
Got it. Super helpful. Thank you so much.
Operator (participant)
Thank you. Our next question comes from a line of Fatima Boolani from Citi. Your line is now open.
Fatima Boolani (Managing Director and Co-Head of U.S. Software Equity Research)
Oh, good afternoon. Thanks for taking my question. Ken, a question for you. There was a discussion about the routes to market in terms of gaining your market share within the SASE universe and one of those important routes is leverage your install base via converting and graduating a lot of the SD-WAN customers.
So my question for you is, how should we think about the potential for the cannibalization of some of your refresh potential as that migration journey transpires from SD-WAN to SASE? Then I just have a follow-up for Keith, if I may.
Ken Xie (CEO)
Yeah. It's another very good question. I think if you look at the customer, a lot of SASE is really supporting the ZTNA and also remote work environment. So they're not cannibalizing any network security firewall deployment, which tends to be more in the office in the headquarters there.
On the other side, it's mostly if you're looking at our current SASE growing strength, it's mostly come from the current SD-WAN customer base or even the firewall customer base there. So that's where they do need a hardware firewall SD-WAN there to support in the SASE with the additional SASE user license, with additional all these other function service add-on there. So that's where we see both three pillars, whether the secure networking side and also the SASE side, which will help in adding additional service.
Plus, the other we call the secure operation side, all kind of starting growing now. So, we do believe we can keep on growing all these three areas faster than the market, keeping gaining market share, especially SASE, the technology we can put all in the same OS with ASIC or security, and also supporting both the cloud-based SASE or the private SASE or Sovereign SASE is a huge advantage.
Also, we also believe eventually the service provider carrier will play some important role in the SASE and offer a lot of their own kind of SASE to their customer. So, that's where we are very strong supporting all the service providers build their own SASE infrastructure and, we do feel it's a huge growth potential on top of the traditional network firewall market.
Fatima Boolani (Managing Director and Co-Head of U.S. Software Equity Research)
Thank you, Ken and just Keith, for you to double back on the end-of-support catalyst around the refresh that you're talking to and telegraphing for 2026. Any way you can give us a lens on either the proportion of the shipment footprint or the installed-base footprint or the customer footprint that this applies to in the aggregate? Thank you.
Keith Jensen (CFO)
Yeah. At the risk of taking all the fun out of the analyst day in 10 days, I would say that Q2 2023 was or Q2 2022 was the second highest I looked at. 2026 is a little bit more than 2X 2023.
Fatima Boolani (Managing Director and Co-Head of U.S. Software Equity Research)
Thank you.
Keith Jensen (CFO)
So you're not coming to the Analyst Day?
Fatima Boolani (Managing Director and Co-Head of U.S. Software Equity Research)
Will be.
Operator (participant)
All right. Thank you. Our next question comes from the line of Saket Kalia from Barclays. Your line is now open.
Saket Kalia (Senior Equity Research Analyst)
Awesome. Hey, guys. Thanks for taking my questions here. Maybe for Keith or Christiane, I think we mentioned a SASE Solutions ARR growth number in the prepared remarks. Could you just remind us, is that an organic or inorganic number and maybe just touch on what are the solutions that are driving that growth?
Keith Jensen (CFO)
Christiane, you want to?
Christiane Ohlgart (Chief Accounting Officer)
Yeah. So the growth number that Keith referenced was an organic growth number. We did not include the ARR that we acquired from Next DLP and Lacework. So the growth would be even higher. Year-over-year would be 150%.
What are the solutions, the organic solutions that are driving the SASE ARR growth is really FortiEDR, FortiClient, FortiNDR, cloud, FortiWeb. So a variety of our cloud solutions and SASE solutions that we've started to offer. Some of them are acquired. Some of them are internally developed.
Saket Kalia (Senior Equity Research Analyst)
Got it. Keith, maybe for my follow-up for you, just to shift gears a little bit, it was great to see the profitability again. Could you just remind us what you mentioned something about being one-time in nature in the quarter? It sounded small, but could you just remind us what that was? More importantly, do you think about this as a more sustainable level of profitability?
Keith Jensen (CFO)
Yeah. I think if I were to use the headline first, I would say the pro forma margins, if you back out that one-time benefit, product gross margin would have been about 68.45%, and operating margin, if you backed out that benefit, would be 35.1%. As you may recall, we have two different things that are impacting our margins in that regard. One is the traditional excess and obsolete inventory calculation with inventory you have on hand.
That's pretty straightforward in comparison. The second one is future deliverables, and the operations team has worked really hard over the last year negotiating and renegotiating those, and we saw a benefit there that kind of pencils out to those margins I gave you. In round numbers, we got a benefit there of about $15 million. That's very unusual. We've not seen that in the past.
Saket Kalia (Senior Equity Research Analyst)
Anything on sort of the sustainability of that margin? If that risks pulling anything from the analyst day, I totally understand. But wanted to make sure the question was asked.
Keith Jensen (CFO)
Yeah. I think we feel really good about the profitability of the business, and I think it comes back to where those investment vectors that Ken and John Whittle and others are going to really focus on as we go forward and how we want to invest there. But I think we certainly have ample room to invest in the growth of the company.
Saket Kalia (Senior Equity Research Analyst)
Very helpful. Thanks.
Keith Jensen (CFO)
All right.
Operator (participant)
Thank you. Our next question comes from a line of Tal Liani from Bank of America. Your line is now open.
Tomer Zilberman (Senior Analyst)
Hey, guys. You have Tomer Zilberman on for Tal Liani. Just wanted to ask about the billings guidance for next quarter. The organic billings X, Lacework, and Next DLP came in well below street expectations. Just wanted to ask where you see the weakness and how you measure that against the comments of seeing stable firewall demand this quarter and the expected refresh cycle in 2025?
Keith Jensen (CFO)
Yeah. Great question. I think what we're seeing when we look at the fourth quarter right now, we're really pleased with what we got out of the very first month of the first quarter and I think that the second month is early yet is tracking. What's giving us pause are some chunky deals that are teeing up for the final month of the quarter.
They just need to mature a little bit more before we start thinking about them as part of our guidance numbers. So I think it's really that population of a large seven-figure and a few eight-figure deals that are kind of coming into play there a little bit.
Tomer Zilberman (Senior Analyst)
Got it. Maybe to follow up, asking more generally about the competitive landscape. We've seen over the last couple of quarters, some of the larger vendors are now focusing even more on discounting, bundling, and vendor financing. So how do you see the competitive landscape? Do you see any pricing pressure because of that and how are you participating with that as well?
Keith Jensen (CFO)
Yeah. I think maybe Christiane will add a couple of comments here as well. But I think the discounting was very similar to what it's been in prior periods. As I mentioned, we certainly have ample margin to invest in a wide range of ways and we're encouraging our sales team and our channel partners to take part of that. But I think there's also been some other changes in terms of incentives that we offer as well. But maybe Christiane has some thoughts as well.
Christiane Ohlgart (Chief Accounting Officer)
Yeah. I think overall, the discounting, we expect to be pretty stable, but of course, it depends on the product set a little bit, and then, yeah, we have incentives in the market for channel partners specifically, but also for our customers to buy more Fortinet solutions.
Tomer Zilberman (Senior Analyst)
Got it. Thank you very much.
Operator (participant)
Thank you. Our next question comes from a line of Gabriela Borges from Goldman Sachs. Your line is now open.
Gabriela Borges (Managing Director and Senior Software Equity Research Analyst)
Hi. Good afternoon. Thanks for taking my question. Keith and Ken, I wanted to ask you about the go-to-market and more specifically, I think it's been about a year since you upleveled your sales force around SSE. What are some of your learnings? What do you think is working well and what do you think is incrementally a focus as we go into 2025 where you think you can maybe uplevel some more? Thanks.
Ken Xie (CEO)
Yeah. You can see the last 12 months, we made a huge progress in the SASE SSE go-to-market directly, but also you can see Q3, some of the service providers also finally setting terms with us now and realized the importance of the SASE into their customer base, but it probably still takes some time, but on the other side, we see our own customer base really like the SASE and the very easy migration from the firewall SD-WAN into SASE.
So that's come to probably 90% of our SASE business come from existing network security and also SD-WAN customer, and that actually helped us sell additional service, additional margin there. On the other side, the technology we have, whether the single OS, the ASIC, security, all these functions give us huge advantage to expand beyond traditional SASE market, which is only focused on the cloud-based SASE.
So that's where we see whether the Sovereign SASE, private SASE, or even beyond go to the edge computing area with all kind of technology with our clients also here, especially for the OT/IoT area. Both the hardware agent, software agent to supporting all these OT devices, we see also huge growth potential there. So that's where we're pretty confident. So we're leading the SASE market and just like we did in the firewall SD-WAN space.
Keith Jensen (CFO)
Yeah. I think that Ken's got it.
Gabriela Borges (Managing Director and Senior Software Equity Research Analyst)
That makes sense. Thank you. Please go ahead.
Keith Jensen (CFO)
Yeah. I think that's spot on with that. I think that if you compare and contrast where we are today versus a year ago, what I would say is that given the response that we get from customers when they meet with us, they're very excited about the architectural design of SASE that we've taken.
What we really want now is just more at bats. When customers sit down with us and hear that story, it resonates with them and you see that in some of the pipeline numbers and some of the ARR numbers that we're talking about, which are still very early days. I think part of that is getting more reference customers involved. I think also we need to partner more closely with the channel to make sure that we're getting more at-bats on those SASE opportunities.
Ken Xie (CEO)
Yeah. What I just wanted to say is all SASE also had infrastructure. We're also different than pretty much all our competitors. I think, like I said, we own more than three million sq ft of our own kind of facility, which if our own data center can deliver the SASE function, probably less than half compared to all these colo and then also kind of only 10%-20% cost compared to some cloud provider.
But we're definitely working with them because they have also good coverage. So that's where for us, we do have a cost advantage on the infrastructure side. Plus, on the OS technology, on the ASIC acceleration can lower the energy cost within the data center, within all the SASE processing.
I think we do have a huge advantage both on technology, from the infrastructure, and also leverage a business customer base we have on the firewall SD-WAN. So that's the three advantages we have over all other SASE competitors.
Keith Jensen (CFO)
I think it's also interesting to note, like you said, we started really focusing on SASE a year ago. Like Ken said, we've been building the solution for some time, of course. A year ago, at the November 2023 earnings call, right around that, we broke out those two other pillars, SASE and SecOps, externally and also internally to focus on those pillars.
You've seen really nice growth when we focus on solutions like that over the past year. It's only been a year, and I think it's a little analogous when you think about kind of Fortinet's ability to execute. If you look at SD-WAN, which we started to really focus on in 2018, and now we've risen to be the leader in the Gartner Magic Quadrant, it steadily grew over time.
So I think that those past results delivered around SD-WAN are illustrative of what Fortinet can do when they focus on things and we've really been focused on SASE and SecOps for that year. So I think we've had really good results over the course of that year in a very short period of time and a lot more focus to come going forward.
Gabriela Borges (Managing Director and Senior Software Equity Research Analyst)
Absolutely. Good stuff. Thank you.
Keith Jensen (CFO)
Thank you.
Operator (participant)
Thank you. Our next question comes from a line of Shaul Eyal from TD Cowen. Your line is now open.
Shaul Eyal (Managing Director and Senior Analyst)
Thank you. Good afternoon, guys. Ken or Keith, in your press release, you're talking about Fortinet being well-positioned to lead in its three core growth areas and drive sustained growth. Keith, again, I don't want to spoil the analysts. They will front-run it in advance. But sustained growth, what are we talking here? Low teens, mid-teens, any color will be highly appreciated.
Keith Jensen (CFO)
Yeah. I appreciate the opportunity to talk to it. Maybe Ken wants to a little bit, although I would probably be careful what he says. I think, well, obviously, we'll talk about 2025 as we get to the February earnings call. We understand that the November analyst day is probably going to bake in some of the 2025 conversation. I think it's a well-structured question, but I think we'll pause on answering it for now.
Ken Xie (CEO)
Yeah. I agree. So probably waiting for 10 days. Also, you can look at the investor slide, probably number six. There's some information there and we probably will provide more detailed information about total addressable market, how we want to grow faster in the market in each sector.
Shaul Eyal (Managing Director and Senior Analyst)
Thank you.
Operator (participant)
Thank you. Our next question comes from a line of Rob Owens from Piper Sandler. Your line is now open.
Rob Owens (Managing Director and Senior Research Analyst)
Great. Thanks for taking my question. Keith, I wanted to, I guess, double back on your comment around Q4 and some of the chunky deals setting up for the final month of the quarter, giving you a bit of caution.
Was that not in your purview, I guess, when you were looking at the setup for the second half before? Have these things somewhat slipped relative to maturation, your ability to get them across the line? Just curious why the additional conservatism around them now. Thanks.
Keith Jensen (CFO)
Yeah. Great question. I do think that compared to what I've seen in other quarters, maybe a little bit less or a little bit slower progress on the maturation on those larger deals in the third quarter as they got teed up for the fourth quarter. Certainly not shutting them out. I think it's more prudent right now to take a more cautious approach and let them mature a little bit.
Ken Xie (CEO)
Yeah.
Rob Owens (Managing Director and Senior Research Analyst)
All right. Appreciate it, guys.
Ken Xie (CEO)
It's an honor, in fact. It's really probably the first time we also starting give the RPO number. Also compared to one year ago, some of the deals, probably Christiane can give more detail. Instead of financing from the channel, get a billing right away for multiple-year deals, some of them may just using RPO, just bill annually. Maybe Christiane knows this better.
Christiane Ohlgart (Chief Accounting Officer)
Yeah. As you can imagine, the customers won't pay multi-years upfront. So we have internal discussions around either letting the channel finance or do it ourselves and this is also not matured enough to be comfortable guiding in that direction, but gives us some pause because some customers just don't want to sign up for long periods without financing.
Ken Xie (CEO)
Yeah. This maybe has a little bit short-term impact, but also will benefit the company long-term with better margin, better customer relation. So that's what we're all looking for: long-term success.
Operator (participant)
All right. Thank you. Our next question comes from a line of Catharine Trebnick from Rosenblatt. Your line is now open.
Catharine Trebnick (Senior Research Analyst and Managing Director)
Oh, hi. Catharine Trebnick here. Thanks for taking my question. Can you discuss how your virtual firewall is performing this quarter or the trends for it? Competitively, we've been picking up that Microsoft and Google have been doing a really good job with their virtual firewall. So how is that standing competitively with you? Thank you.
Keith Jensen (CFO)
Yeah. I think that the virtual firewalls have done very, very well. It is a component of Unified SASE as well as part of our network security portfolio and I think the other thing that we looked at is the crossover that we see, which is a very strong relationship between the-
Catharine Trebnick (Senior Research Analyst and Managing Director)
Tory, I'm on another call.
Keith Jensen (CFO)
You still there, Catherine? Well, I'll just finish this up. I think one thing we will talk about later this month is just the strong overlap that exists between our enterprise customers that are buying both physical appliances and virtual appliances. Yep.
Operator (participant)
All right. Thank you. Our next question comes from a line of Adam Borg from Stifel. Your line is now open.
Adam Borg (Managing Director and Senior Equity Research Analyst)
Great. Thanks so much for taking the question. Maybe for Ken, just on the latest work for the CNAPP offering now, I'd love to hear a little bit about initial customer feedback, partner feedback, and kind of near-term R&D and sales and marketing priorities. Thanks so much.
Ken Xie (CEO)
Good job, man.
Keith Jensen (CFO)
Yeah. I mean, I think the feedback we're getting is similar to what we found. This is John Whittle, by the way. What we found when we did our diligence: great product, great engineering team. It's an incremental TAM of $10 billion for us. So it really opens up that incremental TAM. Now we have cloud security, endpoint, network, and we have great threat intelligence from all three.
So I think it's very, very positive feedback in terms of the quality of the product. We're continuing on the roadmap to improve the user interface in other areas and really make it a really, really, really strongly competitive product. I think it's very competitive against some who have kind of pieced their solutions together based on multiple acquisitions forming their CNAPP solution.
So what we find is, in that context, oftentimes, we hear this feedback from customers a lot: their solution does not work well together. It's poorly integrated, but it's not. Lacework CNAPP solution was largely developed organically by them to all seamlessly work together. So we're hearing really positives on that front.
Then also versus other competitors, we do have this broad suite of products that we can offer together versus other kind of single product vendors who just offer CNAPP. So we have real competitive differentiators against the others in this space that we see working to our advantage.
Ken Xie (CEO)
Yeah. So both companies have a market-leading technology, and the team there are also pretty strong. At the same time, also kind of better as a company. So we're keeping our own kind of solution, integrated solution there.
That's probably better than other competitors who actually leverage our customer base, leverage our also strong R&D resource, have both combined solution and also stand-alone solution to supporting customers in this new $20 billion total addressable market. I think it's definitely added huge growth potential, both in the SecOps and also in the SASE space.
Adam Borg (Managing Director and Senior Equity Research Analyst)
That's great. Maybe just as a quick follow-up, just on the government vertical, obviously, 3Q is important for the U.S. Fed. I know the Fed's a little bit smaller of a vertical for Fortinet. But maybe talk about the government vertical more broadly in the quarter and how you think about it in coming periods. Thanks so much.
Hamza Fodderwala (Executive Director of US Software Equity Research)
Yeah. To your point, we're not really aligned with the U.S. Fed part of the market. For us, the government part is more state and local as well as international government. So you don't really get the same sort of 9:30 A.M. benefit that maybe some other companies see.
Adam Borg (Managing Director and Senior Equity Research Analyst)
Great. Thanks again.
Operator (participant)
Thank you. Our next question comes from Patrick Colville from Scotia. Your line is now open.
Joe Vandragon (Analyst for Fortinet)
Hi. This is Joe Vandragon for Patrick Colville. Can you guys talk more about how you're enabling or incentivizing partners to kind of lead with Fortinet SASE when they may already have existing relationships with more established vendors in this space? Thanks.
Ken Xie (CEO)
Yeah. You can see the Fortinet channel partner. You can see a lot of the actuality is our partner for network security and also SD-WAN. So it's a very easy upgrade path to our SASE, and a lot of them also compare to whether the cost, the security, the performance, the flexibility, the broad range; we also much better than any other competitor.
So it's a quite easy migration from some of our competitors to Fortinet, so we do see some kind of acceleration there. The other part is also we have a pretty big SMB customer base. SMB right now probably only single digit has any kind of network security deployment.
We also see that's also one of the fast-growing areas because they do suffer a lot of advanced network attack, all these kind of things, so we do see there's an additional segment we can grow.
At the same time, for service provider, for big enterprise to do this private Sovereign SASE, that's also none other competitor can offer, whether in the same OS or do the local data center deployment within the customer premises there. That's where we feel we have quite some differentiation can give us huge advantage over other competitors.
Joe Vandragon (Analyst for Fortinet)
Got it. Thanks, Ken.
Operator (participant)
Thank you. Our next question comes from a line of Joseph Gallo from Jefferies. Your line is now open.
Joseph Gallo (Senior Vice President and Software Research Analyst)
Hey, guys. Thanks for the question. It was great to see the OT grew 19% billings growth. How should we think about the sustainability of that business? Then are there any changes in that competitive landscape?
Keith Jensen (CFO)
I think we're very bullish on the OT market, but the leadership opportunity for us.
Ken Xie (CEO)
Yeah. OT is the other area we really lead in the space. In some report, we're the only leader in OT security. We also believe in investing this year for a long time. Also we believe in the next 5-10 years, probably most of the connections that will come from this device level, and which most of them probably have a difficult way to deploy the agent software on this device. You have to use network security.
So we see a huge opportunity. This OT combined results in edge computing. We feel it will be the strongest growth area in the next 5-10 years. So, leveraging with our OS and ASIC technology and also the infrastructure we have. We feel there's a huge opportunity there. We'll be driving or definitely will drive the long-term growth.
Joseph Gallo (Senior Vice President and Software Research Analyst)
Then maybe just to double-click on retail and some of the verticals, it was great to see that that grew for the first time, I think, in six quarters. Now that we're post-election, are there any verticals that you expect to rebound, or are there any changes going forward over the next couple of quarters that we should expect? Thank you.
Ken Xie (CEO)
We see the manufacturing already pretty strong in Q3. We feel the post-election probably that's also keeping accelerating there. Also, the other one, like carrier service provider, is out of the market. We feel finally see some growth after probably six quarters.
Yeah, probably some other retail, it's a pretty strong growth in 2001, 2002, 2021, 2022, almost like 100% growth in that year. So I think that's probably will be most starting getting the refreshing cycle, starting whether next year or 2026, because we see the number of units in that space registered been goes through all these last four years. They probably more reach to the time to refresh now.
Operator (participant)
Thank you. Our next question comes from a line of Keith Bachman from BMO. Your line is now open.
Keith Bachman (Managing Director and Senior Equity Research Analyst)
Hi. Many thanks. Good evening. I wanted to ask two questions, sort of a micro and a macro, and I'll just ask them concurrently in the interest of time. Keith, just on the SASE penetration, you indicate in slide nine about 45% is with large enterprise.
If you took out the SD, and it's a very impressive figure. If you took out the SD-WAN, what would that penetration rate or share look like in terms of customer type? I'm just trying to understand the SD-WAN versus the other bucket. Then the second question is a broader question, but how are you thinking about Europe as you look out over the next quarter or two?
I know it's T+1 in terms of the election and what economic growth may be as a consequence, but just how are you looking at Europe over the next couple of quarters, not just in Q4? That's it for me. Thank you.
Keith Jensen (CFO)
Yeah. Maybe we've confused you or I've confused myself on slide nine. I don't think that's showing penetration. I think that's showing mix of customers.
Keith Bachman (Managing Director and Senior Equity Research Analyst)
Yeah. Sorry. That's what I meant. But what would the just mix of customers if you took out SD-WAN of the SASE piece alone?
Keith Jensen (CFO)
You're going to find a mix of customers that's more tilted to the larger enterprises if you look at SASE alone than when you look at the entire universe, would be my expectation. I think you said yeah. Okay. When you look at dollar values, right? Not customer accounts.
Keith Bachman (Managing Director and Senior Equity Research Analyst)
Yep.
Keith Jensen (CFO)
Okay. Okay. Europe, I mean, Europe was, I think we mentioned on the call, international or EMEA was number one. I think U.S. was number two, and Europe was right behind them at number three. It's a little bit like the SMB headlines that we talk about every quarter, that the economy is slow, everybody worries about SMB, and it continues to do well. I'm not saying there aren't pressures in Europe, and as we look forward to the fourth quarter, I don't know that we're expecting anything like an outsized performance from Europe, but we'll see how the quarter comes out.
Keith Bachman (Managing Director and Senior Equity Research Analyst)
Okay. Thank you.
Keith Jensen (CFO)
Okay.
Ken Xie (CEO)
Thank you. Our next question comes from a line of Junaid Siddiqui from Truist. Your line is now open.
Junaid Siddiqui (Research Analyst)
Great. Thank you for taking my question. I just wanted to drill down in your hardware appliances, and if you could maybe just give us a little bit more color how the high-end family perform versus the mid-range and the lower end. Thank you.
Keith Jensen (CFO)
Good question. I'm looking for some numbers real quick here.
Christiane Ohlgart (Chief Accounting Officer)
So overall, I would say mid-range and high-end has continued to be stable, but not outgrowth. We had a little bit more unit shipment in the end.
Keith Jensen (CFO)
I guess what we're saying is there's nothing that jumped off the pages when we look at our numbers. How's that?
Junaid Siddiqui (Research Analyst)
Great. Thank you.
Keith Jensen (CFO)
Okay.
Ken Xie (CEO)
Our final question comes from Gray Powell with BTIG. Gray, your line is now open.
Gray Powell (Managing Director and Security and Analytics Software Analyst)
Oh, great. Thanks for working me in. I greatly appreciate it. So yeah, it was really helpful to see the product-level billings growth rate disclosures on the slide deck. Within Universal SASE, could you maybe give us a ballpark sense as to how fast the SD-WAN piece is growing?
My understanding is that that's probably been under pressure over the last 18 months. So I guess my question is really like, do you see potential for that product to re-accelerate, particularly as VMware customers start looking for alternative solutions? Thanks.
Keith Jensen (CFO)
Yeah. I think if you look at our SD-WAN space, and I think we made reference to the penetration in the larger enterprises at something on the order of 65% or 70%, that is of our customer base. Gray, as you're pointing out, the opportunity for us to see greater growth there is by winning whitespace accounts and bringing them on board with the FortiGate and SD-WAN solution and starting them on that customer journey that goes FortiGate, SD-WAN, SASE.
I think you're going to get some renewals from the early adopters of SD-WAN here as we start looking into 2025 and into 2026. That'll be natural. I think that those same, just as we're going through a renewal cycle for SD-WAN, our competitors will be also. We've historically shown where we have a superior product like SD-WAN, that's an opportunity for us to dislodge the incumbents.
Ken Xie (CEO)
Yeah. I agree. If you look on the top five SD-WAN providers, we are the only one internally developed integrated with security, also the SASE, all these things. All the other comp acquisition, a lot of companies also being sold after acquiring some of the SD-WAN. So their kind of function or technology already stopped developing in a few years now.
Come after refresh, we do see it's a huge opportunity. It's a still very fragmented space, but we do see a lot of replacement opportunity deal right now and we also feel we are not only leading on the technology, but also performance, cost, energy consumption. So that's where we feel the SD-WAN will keep accelerating and grow faster than the market, gaining market share there.
Gray Powell (Managing Director and Security and Analytics Software Analyst)
Understood. All right. Thank you very much.
Keith Jensen (CFO)
Thank you.
Operator (participant)
This does conclude the question and answer portion. I will now turn it back over to Aaron for closing remarks.
Aaron Ovadia (Senior Director of Investor Relations)
Thank you. I'd like to thank everyone for joining today's call. As a reminder, we will be holding an Analyst Day on November 18th, marking our 15-year IPO anniversary, where we will share the company's vision for the future of cybersecurity and provide an update on our strategy and midterm financial model.
We will also be attending investor conferences hosted by Barclays, Needham, Scotiabank, and Wells Fargo during the fourth quarter. The webcast links will be posted on the events 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.
Operator (participant)
This does conclude the conference call. Thank you for being here. You are now free to disconnect.