Fortinet - Q4 2022

Transcript

Operator (participant)

Thank you for standing by, welcome to the Fortinet fourth quarter earnings conference call. At this time, all participants are on listen-only mode. After the speaker's presentation, there'll be a question-and-answer session. To ask a question at that time, please press star one one on your touchtone telephone. As a reminder, today's call is being recorded. I will now turn the conference to your host, Mr. Peter Salkowski, Senior Vice President of Finance and Investor Relations. Please go ahead.

Peter Salkowski (SVP of Finance and Investor Relations)

Thank you, Valerie. Good afternoon, everyone. This is Peter Salkowski, Senior Vice President of Finance and Investor Relations at Fortinet. I'm pleased to welcome everyone to our call to discuss Fortinet's financial results for the full year and fourth quarter of 2022. Speakers on today's call are Ken Xie, Fortinet's Founder, Chairman, and CEO, and Keith Jensen, our Chief Financial Officer. This is a live call that will be available for replay via webcast on our investor relations website. Ken will begin our call today by providing a high-level perspective on our business. Keith will then review our financial and operating results for the full year and fourth quarter of 2022 before providing guidance for the first quarter of 2023 and the full year. We'll then open the call for questions.

Before we begin, I'd like to remind everyone that on today's call, we will be making forward-looking statements. These forward-looking statements are subject to risks and uncertainties, which could cause actual results to differ materially from those projected. Please refer to our SEC filings, in particular the risk factors in our most recent Form 10-K and Form 10-Q for more information. All forward-looking statements reflect our opinions only as of the date of this presentation. We undertake no obligation and specifically disclaim any obligation to update forward-looking statements. 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 the earnings press release and in the presentation that accompany today's remarks, both of which are posted on the investor relations website.

Ken and Keith's prepared remarks for today's earnings call will be posted on the quarterly earnings section of our investor relations website immediately following the 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 (Founder, Chairman, and CEO)

Thanks, Peter, thank you to everyone for joining today's call to review our outstanding full year and fourth quarter 2022 results. For the full year, revenue growth accelerated to 32%. We continue to gain market share in the cybersecurity industry, with customers increasingly recognizing how Fortinet's integrate at a single platform approach to security delivers a low total cost of ownership and a greater return on investment than competing solutions. Product revenue growth of 42% was very strong, making Fortinet a leading product revenue company in the cybersecurity industry, with total product revenue of $1.8 billion. SD-WAN and OT bookings together accounted for over 25% of total bookings. Our goal is to keep growing and achieving number one market share in network firewall, secure SD-WAN, and OT security market over the next couple of years.

For 20 years, Fortinet has laid long-term strategies and investment around the convergence of networking and security. Yesterday, we announced our fifth generation FortiSecurity Processor, the FortiSP5. This new SoC-based FortiASIC has secure computing power ranging from major network security functions like firewall and VPN throughput that are 17-32x greater than the average of our competitors' similar price model using general purpose CPUs. It doubles the ASIC chip acceleration of applications to 14, such as Zero Trust, SASE, 5G, and SD-Branch, with much better performance and efficiency.

According to the most recent IDC data on unit shipment of firewall appliance, Fortinet holds the number one unit shipped market share position at 48%, providing Fortinet with an attractive economy of skill position as well as making it difficult for competitors to develop their own ASIC technology due to high entry barrier and significant investment that is required. FortiASIC's huge security computing power advance, advantages are able FortiOS to integrate more security functions and applications than our competitors with much better performance and much lower energy consumption, resulting in a much lower total cost of ownership while offering easier operations for our customers. For example, a recent Forrester report highlighted that customers deploying Fortinet's secure SD-WAN solutions achieved a 300% return on investment over three years with a payback period of only eight months.

Fortinet's substantial install base of product with rich functions enable us to offer additional secure services and upsell, integrate, and automate FortiFabric product and solutions. We recently announced several new and enhanced services that help SOC team reduce their operations cyber risk while being more efficient in handling cybersecurity issues. As networking and security continue to converge and consolidate, we believe we are well positioned to achieve our 2025 billion target of $10 billion. 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. Good afternoon, everyone. As we look back at 2022, we see the success of our strategy to lead in convergence and consolidation, as well as the combined power of our ASIC technology with our integrated operating system. Combined, these efforts are driving our strong financial results. There's been an explosion of devices that must be connected to the cloud data center and edge compute. As a result, the infrastructure has expanded to support secure connectivity via distributed firewalls. It is no longer feasible to overlay security on top of networking in the data center. They must be deployed as a converged solution. Firewalls need to work seamlessly with networking and security applications across a company's entire infrastructure.

Fortinet is leading the convergence trend with a wide range of technologies, including network firewalls, secure SD-WAN, 5G, and OT security, all embedded in our single operating system, delivered as hardware, software, cloud, and as a service. Traditional CPU-based solutions are very inefficient at supporting both networking and security. That's why Fortinet developed proprietary ASIC technology to build an application-specific solution.

Yesterday, as Ken mentioned, we announced our next-generation ASIC, the Fortinet Security Processor or FortiSP5, which allows line speed convergence of networking and security at every network edge. The new 7-nanometer technology combines existing NP7 technology with new content processor capabilities. Our enhanced platform suite of integrated products is delivering on customer demands for convergence, vendor consolidation, ease of management, and lower operating costs. The success of the strategy is evident in our full year 2022 results. I'll start there. Billings passed the $5 billion mark, totaling $5.6 billion and growing 34%, while revenue totaled $4.4 billion, with growth accelerating to 32%, the fifth consecutive year of revenue growth of 20% or more.

Driven by strong demand for our fabric and cloud security solutions, enhanced platform technology billings and revenue both increased over 40% to $1.8 billion and $1.5 billion, respectively. Despite a challenging global supply chain environment, product revenue growth came in at 42%, our highest annual product revenue growth rate in over 10 years. Our product revenue growth was driven by the continued growth of our firewall use cases and the addition of over 23,000 new customers. Service revenue was up 26% to $2.6 billion, resulting in three consecutive years of accelerating service revenue growth rates. Gross margin was strong at 76.3%, and operating margin outpaced our initial expectations, increasing 110 basis points to a new Fortinet record high of 27.3%.

Our GAAP operating margin of 22% is one of the highest in the industry. We continued our streak of being GAAP profitable every year of our 14-year history as a public company. Earnings per share increased 49% to $1.19. Free cash flow was a record at $1.45 billion. Free cash flow margin was 33%. Adjusted for real estate investments, the free cash flow margin came in at 37%. For the year, we repurchased approximately 36 million shares at a cost of $2 billion. Total deferred revenue increased 34% to $4.6 billion. Short-term deferred revenue increased 32% to $2.35 billion. Quarterly contract terms throughout the year were consistent with the year earlier periods, including the fourth quarter at 28 months.

Before moving on to our Q4 results, I'd like to summarize our enterprise success and highlight a few seven-figure deals from 2022. We saw great success during the year with our strategy to expand further into the large enterprise segment as the number of deals over $1 million increased over 55% to a record 546 deals. Billings on these deals increased by over 70%. If we look at a few of our large deals of the year, let's start with a competitive upsell deal. Fortinet displaced 11 different vendors by consolidating the customer's network and security functions on our Security Fabric. This worldwide wholesaler previously purchased secure SD-WAN and FortiProxy. Next on their list was a centralized network security solution that could be managed and deployed to its 400 global locations.

This customer chose Fortinet's Security Fabric for its flexible and integrated solution across multiple scenarios, including work from anywhere, perimeter security, and data center segmentation. Another upsell deal, a leading global manufacturer was spun off and had to stand up their security and networking infrastructure separately. The newly created infrastructures included remote access, SD-WAN, application delivery control, authentication, endpoint, email protection, and switching. Keys to our win included our Zero Trust capabilities, a cloud-first SD-WAN strategy, and the ease of integration and convergence across our platform suite. In a new logo win, a large U.S. retailer with over 500 locations was struggling with the total cost of ownership of their legacy security architecture.

Keys to this win included delivering a single pane of glass versus the multiple consoles they were using, and replacing the competitor's firewalls with our FortiGates, delivering URL filtering, Wi-Fi security, and edge router replacement, all on our unified and integrated FortiOS platform. This customer reported anticipated savings of $29 million over five years. Turning to Q4 results, both billings and revenue delivered new Fortinet records with billings of $1.7 billion and revenue of $1.3 billion. Both metrics increased over 30%. The strong fourth quarter revenue performance reflects solid customer demand across both our core and enhanced platform technologies. In the fourth quarter, we added over 6,200 new logos, another new Fortinet record, reflecting the support of our channel partners, the leverage they bring, and the breadth of our worldwide customer base.

Taking a closer look at the fourth quarter, billings growth of 32% was driven by a 40% increase in enhanced platform technology billings, which accounted for over 1/3 of total billings. Total revenue growth of 33% was driven by strong demand for core and enhanced technology platforms, which increased 26% and 47% respectively. Product revenue grew 43% to $540 million. Service revenue was up 27% to $743 million, driven by strong product revenue growth and strength in our security subscriptions. Short-term deferred revenue grew 32% and represents eight consecutive quarters of accelerating growth rates. Total gross margin of 77.6% was driven by a 310 basis point increase in product gross margin to 65.2%.

Several factors converged to drive our record high quarterly product gross margin, including legacy pricing actions, easing supply chain cost pressures, and improved discounting. Service gross margin of 86.7% ticked down 40 basis points due to increased labor costs and our expansion in cloud services and the related hosting costs. Operating margin of 32.5% was up 400 basis points year-over-year due to the strong gross margin performance and FX benefit. Looking to the statement of cash flow summarized on slides 11 and 12, free cash flow was $497 million. Adjusted free cash flow, which excludes real estate investments, was $510 million, representing a 40% adjusted free cash flow margin. Cash taxes were $63 million. Capital expenditures were $31 million, including $13 million for real estate investments.

DSO increased 14 days sequentially and year-over-year to 89 days, also impacting service revenue growth. Moving to guidance. We believe the continued innovations we've made in building our platform enables our customers' digital transformation journey. As Ken noted, customers are increasingly recognizing how Fortinet's integrated and single platform approach to security can deliver a lower total cost of ownership and a greater return on investments than competing solutions. I'd like to review our outlook for 2023, summarized on slide 15, which is subject to disclaimers regarding forward-looking information that Peter provided at the beginning of the call. For the first quarter, we expect billings in the range of $1.415 billion-$1.465 billion, which at the midpoint represents growth of 24%.

Revenue in the range of $1.18 billion-$1.22 billion, which at the midpoint represents growth of 26%. non-GAAP gross margin of 75%-76%. non-GAAP operating margin of 23%-24%, which at the midpoint represents an increase of 150 basis points. non-GAAP earnings per share of $0.27-$0.29, which assumes a share count of between 795 million and 805 million. Capital expenditures of $80 million-$110 million. non-GAAP tax rate of 17%. Cash taxes of $20 million. Should also note the first quarter guidance assumes backlog decreases slightly during the quarter.

For the full year, we expect billings in the range of $6.71 billion-$6.79 billion, which at the midpoint represents growth of 21%. Revenue in the range of $5.37 billion-$5.43 billion, which at the midpoint represents growth of 22%. Total service revenue in the range of $3.335 billion-$3.365 billion, which at the midpoint represents growth of 27% and implies a fourth consecutive year of accelerating service revenue growth. The service revenue guidance also implies product revenue growth of 15%. Non-GAAP gross margin of 75%-76%. Non-GAAP operating margin of 25%-26%.

Non-GAAP earnings per share of $1.39-$1.41, which assumes a share count of between 805 million and 815 million. Capital expenditures of $400 million-$450 million due to continued investments in clouds, data centers, and facilities. Non-GAAP tax rate of 17%. Cash taxes of $375 million split somewhat evenly between the first and second half of the year. The increase in cash taxes reflects recently effective R&D capitalization and amortization requirements. The full year estimate assumes backlog approaches historical levels by the end of the year. Cybersecurity, though not immune to economic slowdowns, is expected to remain a comparatively safe harbor. With a strong business model and history of execution, we are confident that our market share gains will continue.

We remain on track to achieve our 2025 financial targets, which include billings of $10 billion, revenue of $8 billion, non-GAAP operating margin of at least 25%, and adjusted free cash flow margin in the mid to high 30% range in 2025. With that, I'll now hand the call back over to Peter to begin the Q&A session.

Peter Salkowski (SVP of Finance and Investor Relations)

Thank you, Keith. Operator, please open the call for questions. One reminder to the participants. During the Q&A, we ask that you please limit yourself to 1 question and 1 follow-up question to allow others to participate. Open up the call, please. Thank you.

Operator (participant)

Thank you. Again, ladies and gentlemen, if you'd like to ask a question, please press star one one on your touch-tone telephone. Again, to ask a question, please press star one one. One moment, please. Our first question comes from Brian Essex of J.P. Morgan. Your line is open.

Brian Essex (Executive Director and Equity Research Analyst)

Great. Thank you. Good afternoon. Thank you for taking the question. Congrats on some solid results and a solid guide. I guess, you know, given that we heard from one of your peers last night and they were, you know, I guess markedly more conservative or cautious on the macro than you seem to be, maybe for Ken and Keith, could you help us understand, you know, what you're seeing in the market from a macro perspective, how enterprises are spending, and, you know, how did any changes in the quarter relative to initial expectations pan out with regard to demand? You know, we're hearing about sales cycles elongating and budget scrutiny ongoing. You know, what are you seeing on your side?

Ken Xie (Founder, Chairman, and CEO)

I do get quite some feedback from some customer partner. Their budgets are tight, but Fortinet solution has a better cost of a total cost of ownership and also kind of even cost savings for some, like I said, SD-WAN solution. At the same time, we do see the use case of firewall expanding much broader than before, especially for this OT security, some other area, which pretty much I say network security may be the only solution to secure some of this OT, OT area. So that's what we see, that the demand is still pretty strong. So we are probably we're keeping gaining more market share in this rather fragmented market.

Keith Jensen (CFO)

Thanks, Ken. I would spot on with that. I would also add, you know, look, I think we're all sensitive to the overhang from the macro environment and what that may mean as the year progresses. When we look at our internal numbers, you know, whether it's pipeline growth, and even if we compare where pipeline growth is today versus a year ago, it's even up from there in terms of percentage growth rates. You know, the use cases, and I think in this environment, you know, the savings that we offer and the ROI that we provide and some of the case studies that we provided in the call there are examples of that.

You know, I think that, you know, we're continuing to benefit from that, and we do see the continued opportunities for market share gains even in this environment.

Brian Essex (Executive Director and Equity Research Analyst)

Got it. Maybe just for a quick follow-up then, Keith. As you think about the level of conservatism in your fiscal 23 guide, I mean, you know, stronger than I think some had expected. I know I'm gonna get the question tomorrow, you know, how much conservatism is in there. What gives you confidence in hitting that kind of level of performance, particularly with regard to billings? And then any change to your 2025 targets as you kind of look at the strength that you're seeing in the market, from here on out?

Keith Jensen (CFO)

I think that, you know, the approach that we take, if you will, is consistent this time around with what we've done in prior years, but with a certainly added conservatism in it to reflect what's happening or what may happen with the macro environment. You know, first and foremost, we start with the pipeline and looking at the pipeline growth there, and the kind of the timing of the pipeline and making sure that we have deals that are teed up for, you know, the middle of the year and perhaps even to the second half of the year. There's ample opportunity there. You also wanna make sure that you've got sales predictability numbers that make sense and sales capacity numbers that make sense.

I think there will be some tailwind from the backlog, which I commented on in the comment that we're gonna get some benefit from that as it continues to burn down. Keep in mind that, you know, we're, you know, we have seen some changes in cancellation rates, and I think we've added a significant amount of conservatism there, you know, around cancellation rates. You know, again, I think it's, you know, it's really about the pipeline. It's the tailwind that we have, and I think it's the advantages that we're offering in total cost of ownership in this environment.

Brian Essex (Executive Director and Equity Research Analyst)

Okay. That's super helpful. Thank you very much.

Keith Jensen (CFO)

Sure.

Operator (participant)

Thank you. One moment please. Our next question comes from the line of Fatima Boolani of Citi. Your line is open.

Fatima Boolani (Managing Director and Co-Head of U.S. Software Equity Research)

Hey, good afternoon. Thank you for taking my questions. Keith, for you, just with respect to the services revenue guidance at 27%, that's not a material difference from the cadence you've been running at this year. I'm curious, what sort of inputs embed that revenue segment for you? I ask because, you know, we have a dynamic of some of your customers delaying their subscription registrations over the course of 2022. We also have the dynamic of a lot of your customers not having realized the pricing increases that you've effected in the last 12-18 months. I'm curious as to why, with those positive inputs, we wouldn't see better services growth and what sort of things that you're being conservative about there.

A quick follow-up, please.

Keith Jensen (CFO)

Yeah. I think it kinda goes back to Brian's question a moment ago in terms of with the level of conservatism and caution that's in the guide. I know that historically, I've often complained that I don't get much room in the services line from where the consensus is versus what I'm forecasting. you know, at a 27% number, I think that's pretty much right on top of where the street is at for the full year. I think in this macro environment, I think that's, you know, a good place for us to be at this point in the year for full year guidance.

Fatima Boolani (Managing Director and Co-Head of U.S. Software Equity Research)

Understood. Any commentary on operating margin and operating profitability performance, because we are seeing, you know, compression into next year, you know, certainly on a quarterly basis? Anything to be mindful of there as it relates to, maybe one-time items that are peeling out, just perhaps, why not see better follow-through on profitability? That's it for me. Thank you.

Keith Jensen (CFO)

Yep. Yeah, I think our guidance is pretty much in sync with where we are historically at this point in time, and consistent. We always talk about the 25% margin number. I think that what you may be suggesting or inferring is really it's all about FX, if you will, when you look at 2022 compared to 2023. You know, we had a nice benefit from FX in 2022, and I think in terms of what our assumptions are for 2023, you know, like the rest of people, we read the economic reports from the big banks and so forth, and what the dollar's expected to do. I think we've really pulled out a lot of that benefit by the end of this year, so you're not really gonna see that in the year-over-year comparison.

Operator (participant)

Thank you. One moment, please. Our next question comes from the line of Saket Kalia of Barclays. Your line is open.

Saket Kalia (Managing Director and Senior Equity Research Analyst)

Okay. Great. Hey, guys, thanks for taking my questions here. Maybe, first for maybe a question for both Ken and Keith. Clearly, SD-WAN and OT are becoming a bigger part of the business, and that too, with higher growth rates. Maybe the question is: How do you folks think about the growth rate or runway for growth in those two businesses, either separately or together over the next couple of years as, you know, part of the total growth equation or part of the $10 billion goal, however you wanna think about it, but really curious about that SD-WAN and OT part of the business that's been doing so well.

Ken Xie (Founder, Chairman, and CEO)

I think there's a two-part. First, I totally agree with you, Saket. SD-WAN and the OT market growing faster than the network security average. On the other side, we do believe our solution has huge advantage compared to other competitors. Both SD-WAN, OT market is still pretty fragmented and, compared to our home-grown integrated solution and leverage for the ASIC computing power. Our advantage much huge compared to other competitors, quite some more mostly come from acquisition. At the same time, they don't have the ASIC help to increase speed, lower the cost and the power consumption. That's why we feel we're keeping growing above the market, so that... Above the market growth rate.

There's a different research about how the market growing, but I do agree it's a fast-growing market, compared to the cybersecurity space and will be a lot of potential going forward.

Saket Kalia (Managing Director and Senior Equity Research Analyst)

Got it. Got it. Very helpful. Keith, maybe just a quick follow-up for you. Actually, great to see the billings duration stay roughly similar. I'm curious if you could just talk, you know, anecdotally or just specifically around how you're thinking about billings duration here in 23 and whether that's been something that you feel like customers have pushed on given the interest rate environment that we're in?

Keith Jensen (CFO)

Yeah. I don't think that we've really seen customers push on the term. Obviously, you know, at 20 months, you know, 28 months, which has kind of been keeping where we've been historically. I do think in the fourth quarter, we've certainly had conversations with customers that were, I think, perhaps even more focused on cash flow, if you will, than they were on discounting in terms of extended payment terms and that sort of thing. If I were to look at the what I'm hearing back from customers, it was all about cash protection if. With that, you know, I assume if I were trying to do a lot of five-year deals or something like that, I might have felt more pressure.

Given the SMB mix of our business and our partner footprint, it obviously didn't come through in the numbers, really.

Saket Kalia (Managing Director and Senior Equity Research Analyst)

Yeah, absolutely. Great to see. Thanks, guys.

Operator (participant)

Thank you. One moment, please. Our next question comes from the line of Hamza Fodderwala of Morgan Stanley. Your line is open.

Hamza Fodderwala (Executive Director and Senior Equity Research Analyst)

Hey, guys. Thank you for taking my question. Good evening. Keith, I wanted to clarify something you said about the cancellation rates. I think you mentioned that you're seeing some changes there. Can you maybe elaborate on that a little bit? I think, like, the past few quarters, it's been around 4% or 5%. Just if you could provide any more color on that comment.

Keith Jensen (CFO)

Yeah. We did see it tick up to, if we wanna call it mid-single digits in Q3. We saw it tick up to high single digits in the fourth quarter. We've anticipated this, particularly as the backlog starts to shift its mix as the firewalls. There's still a significant amount of firewalls in the backlog, but it really now has tilted towards the networking equipment, the switches and the access points.

As you would expect, one last comment on that, as we see the shift in the mix, as a backlog as well as a tick on the cancellation rates, I would also offer that as part of the guidance-setting process, I think we've taken a fairly conservative approach to cancellation rates and how they may impact 2023. Said another way, we're not expecting all the backlogs that exist at the beginning of the year to convert in 2023 because we think there'll be some cancellations.

Hamza Fodderwala (Executive Director and Senior Equity Research Analyst)

Got it. Just maybe a follow-up for Ken. You know, I think SD-WAN is now nearly a billion-dollar business for Fortinet, which is quite remarkable 'cause you just started selling it, I think, maybe four years ago. I'm curious as more of that base starts to come up for refresh, what other monetization drivers do you see for SD-WAN, whether it be attaching more services or perhaps increasing the price points? I'm curious how you're thinking about that.

Ken Xie (Founder, Chairman, and CEO)

Yeah, definitely more service, whether underlay, overlay service, for SD-WAN because our SD-WAN has all the security function. Also a lot of SD-WAN deploy case, whether supporting, work from home or work from anywhere or kind of helping enterprise reduce their total cost of networking, all these things, we do see a lot of additional service they need. At the same time, we also see the service provider starting more working together with us, offer some quite additional service beyond the traditional SD-WAN. That's also helping drive much more service going forward.

Hamza Fodderwala (Executive Director and Senior Equity Research Analyst)

Thank you.

Operator (participant)

Thank you. One moment, please. Our next question comes from the line of Brad Zelnick of Deutsche Bank. Your line is open.

Brad Zelnick (Managing Director and Senior US Software Research Analyst)

Great. Thank you very much, congratulations on just blowout results and guidance. Nice job. My first question is just around the new ASIC FortiSP5. Can you remind us what, if any, impact we might expect in terms of customer purchasing patterns and what you've seen in the past and the extent perhaps it can drive accelerated demand and/or maybe the risk of trade-down effect? I've got a follow-up. Thanks.

Ken Xie (Founder, Chairman, and CEO)

Probably will take some time, I'd say maybe 1-2 years to refresh the product. That's where every quarter we tend to release one or two product, whether leverage new ASIC or the new CPU or some other network chip in the industry. I don't feel will be significant impact, up and down of the result. It will be more smooth transition because security deployment is a kind of a take long time to design, evaluate, deploy. Also very, very long sales cycle at the same time. The life cycle of the product also tend to be quite long, like 7-10 years.

That's where the ASIC definitely, each generation definitely will help in, and the same time, it's huge advantage compared to using general purpose CPU. That's where we're keeping gaining market share. Consider the switching costs, consider the long cycle, sales cycle and deployment cycle. Also we often need a time to put ASIC into a new product, which also take at least a few months, 3-6 months. That I do see will be like a more long-term positive impact instead of short term.

Keith Jensen (CFO)

Yeah, Brad, I would only offer, again, for context, I think that this is what, Fortinet, been 20 generations of chips, probably now between content processors and network processors and systems on a chip. I think that for what I should say, Ken and Michael have actually shown the ability to transition through those generations of chips. If you look back at the financials, I think it's a little bit difficult to find a year that or a period of time we really saw a spike because of the new chip. These are much more long-term plays. I think that, you know, the approach here is to execute it in a smooth fashion over a number of years.

Brad Zelnick (Managing Director and Senior US Software Research Analyst)

Thanks for the reminder. Keith, can you just expand on your comments around DSOs being up sequentially year-on-year and the impact of services revenue? Related to that, I recall you had a change in policy around subscription activations. Is that also impacting services revenue? Any help there would be great. Thanks.

Keith Jensen (CFO)

The change in activation policy started last week, I believe, February 1st. We'll start to see that going forward. What I was referring to is the DSO is really all about linearity, right? That's what it gives you insights to. If I see my DSO go from, call it 75 days to 89 or 90, you know, you can kind of start doing the math there and see that's a 20% increase in DSO, and it's really driven by, you know, how linearity came through in the quarter. When linearity starts shifting that much, you know, we lose the opportunity to gain service revenue from sales early in the quarter that would normally activate. We really didn't get a lift in service revenue from in-quarter deals the way that we would have expected because of linearity.

Operator (participant)

Thank you. One moment, please. Our next question comes from the line of Shaul Eyal of Cowen. Your line is open.

Shaul Eyal (Managing Director and Cybersecurity Senior Analyst)

Thank you. Good afternoon and congrats on the great performance and guidance. Keith, given the slightly lower than expected, 4Q service revenue, how should we be thinking about the first quarter service revenue growth?

Keith Jensen (CFO)

Yeah, I think that we've kind of remained truthful to or faithful to the notion of providing service revenue guidance for the full year, and then kind of letting the street work out the numbers from that point going forward. You know, I think that, you know, certainly as we kind of looked at laying out the year and with the backdrop of the macro that we're all concerned about, you know, I don't think we really wanted to push too hard on some of the metrics that we didn't need to push on. I think where we ended up with is pretty consistent in the quarter, you know, with our consensus when we look at our internal allocations between product and service revenue.

Shaul Eyal (Managing Director and Cybersecurity Senior Analyst)

Understood. Maybe one more. As we think about the non-GAAP operating margins and really great performance, should we be thinking of the target to be some sort of an average of 25% over the period or a floor of 25% over the course of the next few years?

Keith Jensen (CFO)

I'm gonna answer yes. Yes, you should be thinking about one of those two ways. Look, I think we're driven by being above 25% operating margin, right? Yeah, I think the one thing that the last few years have taught us is life's full of surprises, and so locking into a fixed commitment is a little bit challenging sometimes. You know, clearly we manage the business as if it's a floor.

Shaul Eyal (Managing Director and Cybersecurity Senior Analyst)

Understood. Thank you so much.

Operator (participant)

Thank you. One moment, please. Our next question comes from the line of Adam Borg of Stifel. Your line is open.

Adam Borg (Managing Director and Senior Equity Research Analyst)

Awesome. Thanks so much for taking the questions. Maybe for Ken or Keith, just on sales headcount. You know, obviously you guys have been aggressively growing, sales and marketing headcount in recent years, and it's nice to see the enterprise success you talked about. Just curious where we are in sales force productivity and how we should think about sales headcount growth and even overall headcount growth in 23. I have a follow-up.

Ken Xie (Founder, Chairman, and CEO)

Yeah, we are continuing hiring, but same time we want to keeping the efficiency, at least not dropping the efficiency, for the sales marketing. Same time there's some long-term investment, whether in R&D, the infrastructure supporting we will continually to make. That's where we do expect this, that the total headcount will keep increasing, but probably the rate, just like the last few years, will be below the top line increase.

Keith Jensen (CFO)

Just to build on Ken's comment, one other note is that we do track tenure. We talked about it last quarter. Tenure would be people that have been here. Tenure people have been here for more than six months. I commented last quarter that tenure was up, I think eight points. It's actually moved back to historical norms now. Tenure's kind of a key component of productivity as we go forward.

Adam Borg (Managing Director and Senior Equity Research Analyst)

Got it. Maybe just a quick follow-up just on the FortiGate and entry mid and high. It's nice to see really strong mid-range growth. It's interesting that the high end, at least by mass, was the lowest mix since 2017. Just curious if anything to comment there. Thanks so much.

Ken Xie (Founder, Chairman, and CEO)

That sometimes depend on certain like product or backlogs. I think that's probably the average still pretty similar. We don't see much up and down, but sometimes from quarter to quarter it may change a little bit. I have to say the total mix are still pretty much the same.

Keith Jensen (CFO)

Yeah, I think that's one of the challenges you have in the current environment when the supply chain was really doing funny things, if you will, into delivery, and we don't give you a lot of insights to orders that we were taking in, but we provide billings numbers. You get some distortion there just simply based upon what's available. Specifically, you know, we saw a significant amount of availability of the 100F products, if you will, which are a mid-range product. You're seeing that availability come up, came in the fourth quarter, and it's shifted that mix in the way you just described it.

Operator (participant)

Thank you. One moment please. Our next question comes from the line of Tal Liani of Bank of America. Your line is open.

Tal Liani (Managing Director and Senior Research Analyst)

Hello. Thank you. There's gonna be one day a call that no one is gonna butcher my name, and I'm gonna be very happy. I wanted to ask you two things. First of all, could you provide or backlog for 4Q or anything about it? I'm trying to calculate the bookings for the year and what happens to bookings and any color on backlog would be great. The second question, a few people asked you about the services growth for next year. I wanna ask you about the product growth. The product growth is going from 42%-15%, if my math is right, from last year to next year to this year. On the other hand, your commentary is positive. There's more activity, there's more product sales.

Can you take us through the dynamics of product growth, and also the connection, the relationship between services and products? Thanks.

Keith Jensen (CFO)

Yeah, I'll start with the last one first, if you will. I think that, you know, I think we are very excited about the opportunities in front of us, you know, in terms of how the company is executing. We are certainly also very cognizant of the unknown of the macro environment. I think there's just an opportunity here in terms of how we guide for the full year to really, you know, bake in concerns around the macro and how it may manifest, you know, in the coming months, coming quarters. I think you're seeing that, and I kinda made a comment earlier that historically it's been tough for me to be somewhat cautious on service revenue because it's so visible.

We're looking at short-term deferred revenue, and the conservatism oftentimes ends up in product revenue. I think there's still an element of that in this conversation.

Ken Xie (Founder, Chairman, and CEO)

Yeah. I think for the backlog in, like what I said in last 1 of the quarter, it's continuous shifting to the network gear, network and the Wi-Fi, which is more industry standard product. I'd say probably today most of the backlogs also come from, the network side and the Wi-Fi side, which has a higher consolation rate. That's where we, like as Keith mentioned, we take a pretty, well, it's not conservative, but that definitely pretty good estimate, what will be impact for the whole year, on all this, the backlog for the product revenue.

Product revenue, definitely we see, probably, going forward, the benefit of the new ASIC and also, some of the new products, that they were helping, and also some of the case, the use case, the additional use case, of the firewall definitely also helping. It's, Will take some time. That's where we tend to be, more careful, to forecast. At the same time, we do see long term, we do have a huge advantage, compared to other competitors, because the investment we made, in the, in the product, in the hardware, in ASIC, give us huge advantage of the total cost ownership. We're continuing keeping gaining market share in the space.

Tal Liani (Managing Director and Senior Research Analyst)

Do you provide some numbers about the backlog or maybe how material it is to revenues as a percentage of revenues?

Ken Xie (Founder, Chairman, and CEO)

I think it's since it's been more difficult to forecast at the same time, with the changing consolidation and also most of the backlogs related to networking Wi-Fis, Wi-Fi is not our core product. That's where since last quarter, we no longer provide the detail of the backlog. We feel that that could be a little bit misleading if we keep on providing that.

Keith Jensen (CFO)

I think we can offer you some directional comments. You know, so the headlines would be that, you know, backlog was up year-over-year. Quarter-over-quarter, it was down. As you start, you know, thinking through how to treat the backlog in terms of doing your own models going forward, again, you know, we would come back and remind you of a couple things. You know, we expect the cancellation rates are gonna increase, and that's baked into our guidance, as we look at things. You know, when we say return to historical norms in the commentary, you know, I think we probably would've, three years ago, had backlog for professional services and training that may have been in the $39 range.

maybe with growth now you're probably looking at a steady state that could get you over $40 million-$50 million. just a note of caution, don't just take all that backlog and assume it's all gonna convert into billings and revenue in 2023 given those dynamics.

Tal Liani (Managing Director and Senior Research Analyst)

Got it. Thank you.

Keith Jensen (CFO)

Uh-huh.

Operator (participant)

Thank you. One moment please. Our next question comes from the line of Ittai Kidron of Oppenheimer. Your line is open.

Ittai Kidron (Managing Director and Senior Analyst)

Thanks. Hey, guys. Nice quarter. Keith, I was wondering if you could do a little bit of a deeper dive for us into the enhanced part of your business, if there's a way for you to kind of break it down a little bit for us by product. And perhaps rank order for us categories which are growing above the average for the category and below the average for the category. Would just like to get a little bit more color as to the change in mix within that.

Keith Jensen (CFO)

I don't know that I've really seen a change in the mix, if you will. I think the, you know, when you look at the, what we call the FortiManager, FortiAnalyzer, and certainly the virtual machines are doing very, very well. And then as you start looking at the tail, the fabric products and, you know, in the areas of EDR and monitor and SIEM and so on and so forth, you know, I think that, you know, they're smaller dollar totals, but sometimes very dramatic and exciting growth rates. I wanna be a little bit careful about getting, you know, painting anybody in too great a light in terms of their contribution because, you know, everybody is contributing.

Certainly the networking equipment part of the business has done very well, and this is a key component of this convergent story that we've talked about. It remains, you know, probably, you know, about a third of the fabric business.

Ittai Kidron (Managing Director and Senior Analyst)

Got it. Excellent. Then just going back to the cancellation rate, just to make sure I understand this, how much of this is tied into supply chain, meaning if supply chain isn't getting better, availability is no longer an issue, customers are less, perhaps, interested in getting too far ahead in line in waiting for product. How much of that is a factor in this?

Ken Xie (Founder, Chairman, and CEO)

The supply chain environment definitely had some improvement for networking for the Wi-Fi. That's where sometimes certain customer, they may have a multiple order to see which vendor can deliver because a lot of networking equipment, Wi-Fi is a pretty standard product. Even for us, we do add quite some security function in there. It, sometimes customer just cannot wait, so that's where we see maybe higher cancellation rate. With, I think it's, right now the overall supply chain environment I think is improving.

Ittai Kidron (Managing Director and Senior Analyst)

Got it.

Keith Jensen (CFO)

I think, again, the conversation around cancellation rates, a few things there. You know, we said it went from mid-single digits to high single digits. As we've built it into the guidance, you know, it is a multiple that we've built into the guidance of what we just saw in the fourth quarter. What we actually get out of it, you know, we'll see. The reason to be so cautious about it is what Ken's talking about. You know, we knew that we had an advantage with firewalls in dealing with our suppliers and our vendors, and we thought we'd be successful in pushing down that component of backlog first. Indeed, the mix has shown that. I think it's now something on the order of about 75%, 75/25 between networking equipment and firewalls. Still firewalls in the mix.

As Ken's pointing out is, you know, there, you know, there may be more risk with that networking equipment of cancellations, as we go forward, and particularly as the backlog, you know, for those elements continue to age out a little bit, as we move through this process.

Ittai Kidron (Managing Director and Senior Analyst)

Got it.

Keith Jensen (CFO)

In terms of continuing supply chain challenges, I'm not quite sure I was making the link on that. I don't, you know, I guess I would have an impact on the continuing build of backlog. As we said in our comments, we really expect to get to a backlog number by the end of this year that's much more closely aligned with our historical norms.

Ittai Kidron (Managing Director and Senior Analyst)

Very good. Thanks. Good luck.

Ken Xie (Founder, Chairman, and CEO)

Thank you.

Operator (participant)

Thank you. One moment please. Our next question comes from the line of Andrew Nowinski of Wells Fargo. Your line is open.

Andrew Nowinski (Senior Equity Research Analyst)

Okay. Thank you. Just two quick questions. First I wanna ask you a question on EMEA. You've had five quarters now of accelerating growth in Europe. That seems to defy the macro trends that we consistently hear about in Europe. Just wondering if there's something specific in your portfolio that might be driving that strong growth in Europe.

Ken Xie (Founder, Chairman, and CEO)

I think we definitely have a pretty long tenure and a good team there. At the same time, the case, the firewall case also expand quite well in Europe, in some country there. Some of the service provider carrier, they are a little bit more ahead compared to some bigger service provider where the U.S. are moving some new solutions, including some 5G SD-WAN. That's where we continue to see some good growth there. Also we kind of surprisingly, even during the recession, the S&P sector growing quite strong compared to some enterprise. Enterprise more about how to lower the cost ownership, protect some of their own kind of a profit margin.

SMB, they do see the importance of cybersecurity, especially in the ransomware. They are starting more target SMB right now. We do see quite strong growth in SMB. That's also helping some regions in Europe.

Andrew Nowinski (Senior Equity Research Analyst)

Got it. Okay. I wanted to ask about gross margins. You talked about easing cost pressures and lower discounting as some of the levers that drove that better than expected gross margin. I guess, number one, how sustainable do you think those factors are as we look into fiscal 23? You know, when you launch new ASIC like you did, earlier today, is that a headwind to gross margin initially?

Keith Jensen (CFO)

I think the two things we talked about, price benefits, the discounting, and some easing of the impact of supply chain. You know, I think the price benefit is something that will obviously stay with us in the future, and so we should still get a tailwind from that. However, discounting and supply chains, call it savings for lack of a better term, you know, that's really related to our history of price increases. I think we kind of reached a very, you know, maybe the high water mark in terms of being, having price increases covering those costs, and that'll start to settle back down to a more normalized pattern going forward. Meaning that we'll still have inflationary cost increases, but we've really slowed down the price benefits, price increases.

Net-net, price increases continue discounting and supply chain benefits may not.

Andrew Nowinski (Senior Equity Research Analyst)

Okay, got it. Thank you.

Operator (participant)

Thank you. One moment, please. Our next question comes from the line of Ray McDonough of Guggenheim Partners. Your line is open.

Ray McDonough (VP of Equity Research)

Hi, thanks. Maybe for Ken or Keith. The last time we saw product growth accelerate for two years was back in 2014 and 2015. You had two really strong years of product growth, and that was followed by a pretty sharp deceleration of growth over the next two years. I understand the business is a lot different than it was back then, but there does seem to be some similarities, at least how it relates to the macro environment. Your results obviously point to you guys navigating the macro quite well. You did reiterate your 2025 guidance, which I believe implies mid-teens product growth. I guess the question is, why should we think this time is different? Is it just that you have a significantly larger portfolio of solutions?

Is it broader acceptance from customers willing to consolidate networking and security functionality? Any comparisons or contrasts you can provide specifically as it relates to product growth versus, you know, if you will, the previous cycle would be helpful.

Ken Xie (Founder, Chairman, and CEO)

I think in the 2014, 2015, that's the outbreak of what, Target or Sony case, which a lot of enterprise tried to upgrade from the traditional connection-based firewall to the next-gen firewall, which including some, including prevention, some other things. That's where it's more like kind of refresh, more in the enterprise area. We do see some strong growth there after this cyber issue. This time we see there's a few things. One is really during the pandemic, there's a new infrastructure need to build, supporting work from home, work anywhere. At same time, the ransomware attack quite broadly hit the whole industry. This, another part, we keep seeing the convergence, which is like SD-WAN, the 5G, the Wi-Fi and also internal segmentation.

That's a much broader use case of the firewall deployment, also including OT, a lot of more device being connected. We feel this time is very kind of a more broad firewall use case can apply to the whole infrastructure. That's why we kind of more emphasize the convergence. It's a little bit different than the last time is like eight, nine years ago. That's why we feel this time probably will be more smooth transition because the traditional firewall, whatever, will not go away. At the same time, there's a more use case convergence into the traditional networking area, expanding to the OT, some other area, will help in keeping driving the product revenue growth and then followed by the additional service revenue. That's the things we're planning.

Ray McDonough (VP of Equity Research)

I think that's helpful. If I could maybe a follow-up. You talked a little bit about the momentum in large deals and enterprise deals in 22. Given the macro environment, could you compare and contrast maybe Keith or Ken the behavior you're seeing from larger customers and maybe those on the small on the smaller end of the spectrum? You know, are you seeing more deal delays upmarket, more propensity to consolidate functionality at the lower end? Anything, any more color would be helpful.

Ken Xie (Founder, Chairman, and CEO)

Yeah. It's definitely helping the customer, lower the total cost ownership, both on the management cost and also on the product service cost, which we have huge advantage over the competitors. That's where we see a lot of, big enterprise customer. They definitely want to, when they see the renewal, when they see all this, need to add additional protection for the infrastructure, they do see this, like how to, have a better total cost ownership at the same time, leverage single, integrated platform, automate platform, to offer better security networking together. Even there's a trend to merge, the traditional network operating team and security operating team together. Making the SOC and NOC kind of combine together and also converge of the traditional networking and security together.

We do see some trend happening in the big enterprise and which we, kind of, develop technology and the long-term investment starting to, I mean, starting to benefit for the trend.

Keith Jensen (CFO)

Yeah.

Ray McDonough (VP of Equity Research)

Great. Yeah, go ahead.

Keith Jensen (CFO)

quick. Like everybody else, I mean, you're reading about people talking about deals taking longer to get across the finish line and more approvals and so forth. I don't think we are immune to that by any stretch of the imagination. you know, keep in mind, as we're going through, as the world's moving through this, at the same time, Fortinet's kinda expanding from just seven-figure deals, and I think we talked about 546 seven-figure deals or more last year, if I remember correctly, a huge number. To now adding more and more eight-figure deals. I think we're probably seeing, you know, huge opportunities, but we're also getting exposed to how that approval process works and how we manage, you know, with our sales team, our customers through that process.

Ray McDonough (VP of Equity Research)

Great. Thanks for the color, and congrats on the strong results.

Operator (participant)

Thank you. One moment, please. Our next question comes from the line of Adam Tindle of Raymond James. Your line is open.

Adam Tindle (Managing Director and Equity Research Analyst)

Okay, thanks. Good afternoon. Keith, I wanted to start with pricing. I think we picked up, if we got this right, another, pricing increase announced in January, effective in February. Wondering if you could touch on the rationale and early response to that. Where are we in elasticity of demand? Thinking forward, obviously, costs are ultimately gonna normalize, hopefully in your model. What would be the strategy for you once costs normalize? Would you reduce price or capture margin? Thanks.

Keith Jensen (CFO)

Yeah, the last part first. I mean, I think we'll continue to monitor the market and make the appropriate adjustments there. I don't, you know, seeing inflation go backwards is probably not something that's happened a lot in history, but you know, it could happen, I guess. In terms of the most recent price increase that we talked about, it's almost a non-event to me. It's extremely low single digits gross, and after discounting, it's a fraction of an interest point.

Adam Tindle (Managing Director and Equity Research Analyst)

Got it. Okay. Maybe just as a follow-up for Ken, I wanted to ask on SASE competition. When your main competitors has said they've integrated their SASE offering with SD-WAN and secure web gateway in particular, they're pushing that sales motion across the entire sales force now. As we think about Fortinet, obviously very strong in SD-WAN, but that secure web gateway or proxy piece, is perhaps not as prevalent or a different strategy. It's clearly not impacting your unit market share at present, but just thinking forward to competing and differentiating in SASE now that your competitor's really pushing that motion across the entire sales force. Thank you.

Ken Xie (Founder, Chairman, and CEO)

Yeah. I think we, our strategy, like, you can see in the last few years is, first we want to have a SASE all integrate in the same system, the same OS, including all the SD-WAN, all the SASE function. Making SASE can be more easily broader deploy, and also working with service provider to leverage their infrastructure to offer the SASE. It's a little bit different than some of the SASE player right now in the market. We do believe this is highly integrate into the single system, otherwise will be more efficient and same time will be more secure. That's what we're keeping building.

Wider the new FortiASIC chip, FortiSP5, and also the new FortiOS all reflect all this kind of a development we put into the solution. At the same time, we're keeping working closely with pretty much all the carrier service provider, even cloud provider, to offer SASE together. That's also a little bit different strategy compared to some other SASE player. We do believe long-term leverage infrastructure, a lot of service provider, carrier cloud provider has, will be much more efficient than the profit model compared to some of the SASE solution or player kinda keeping losing money, which will be difficult to last long.

So that's why we will keep investing in this area, and also we want to be a long-term player in this space. Also, we'll be keeping our internal innovation R&D and keeping driving this space.

Adam Tindle (Managing Director and Equity Research Analyst)

Very helpful. Thanks, and congrats on the year.

Ken Xie (Founder, Chairman, and CEO)

Thank you.

Operator (participant)

Thank you. One moment please. Our next question comes from the line of Ben Bollin of Cleveland Research. Your line is open.

Ben Bollin (Managing Director and Senior Research Analyst)

Good afternoon. Thanks for taking the question. Could you share a little bit of what is happening with respect to the cloud infrastructure build-out? Tell us a little bit about what you're doing, where you are in the progress, and customer response thus far. Then I follow up in the networking category.

Ken Xie (Founder, Chairman, and CEO)

Yeah, we continue keeping building out the infrastructure, including the cloud. Our strategy a little bit different than some other player. We tend to build out ourself, just like we, you can see the investment in some of the real estate. Quite some of them also go to the, like a data center infrastructure. That give us much better cost and also more long-term benefit, just like how we, the investment made in early real estate kind of benefit our office cost, our rental cost. That's where we're using the cost saving we get from this rental, keeping invest into some more long-term infrastructure, real estate. We do see that will keeping benefit the company long term.

At the same time, like I said, also partner working with the carrier service provider, that's other strategy we have. Leverage some of their infrastructure. That's also make a win-win. Both party will benefit and will be profit. That's also the strategy we have.

Ben Bollin (Managing Director and Senior Research Analyst)

Within that, Ken, could you speak to, Is it purely cost? Is latency part of the narrative? Is it being closer to your customers? What's the broader strategy within it?

Ken Xie (Founder, Chairman, and CEO)

Not just but also will make it easy to manage, easy to scale. Even some of the SaaS solution, I do believe some bigger customer, they may even do themselves. If you can integrate a multi-session function into the same OS, into the same system, so that's the long-term strategy we have, and also working with service providers is very, very important for us.

Ben Bollin (Managing Director and Senior Research Analyst)

Okay. My last one. Ken, what are your thoughts on the traditional campus, networking opportunity, the WLAN market? How do you think about wallet share opportunity and the ability to displace more of the incumbent there? That's it for me. Thank you.

Ken Xie (Founder, Chairman, and CEO)

That's kind of, the thinking we have, like, over 20, 30 years really. There's a convergence of networking and traditional networking and network security. I think the SD-WAN is a very good example. For secure SD-WAN solution will be more efficient, more secure, and there's a lot of additional service we can apply in our secure SD-WAN, which is whether offer for free or we are not kind of there yet. Same thing for a lot of other WAN technology. We just feel there's a huge potential and also doing security in the networking environment does need a huge company and power, which is come from ASIC investment we made, which also will take a long time to see the return of investment.

That's where we kinda committed from day one, back 23 years ago. When we start, we say, "Hey, we really need to invest and planning all these kind of long-term convergence of network and network security together." The new ASIC chip is one example, is the fifth generation of SoC chip, which also including some of the investment we made in the ninth generation of our content processor and the seventh generation network processor, together with a lot of multi-core CPU. We're continue to develop technology and eventually will be deploy more broadly beyond the traditional network security.

Operator (participant)

Thank you. I'd like to turn the call back over to Peter Salkowski for any closing remarks.

Peter Salkowski (SVP of Finance and Investor Relations)

Thank you, Valerie. I'd like to thank everyone for joining today's call. Fortinet will be attending investor conferences hosted by Baird and Morgan Stanley during the first quarter. A fireside chat webcast link will be posted on the events and presentations section of Fortinet's Investor Relations website for the Morgan Stanley conference. If you have any follow-up questions, please feel free to contact me. Have a great rest of your day. Thank you.

Operator (participant)

Thank you. Ladies and gentlemen, this does conclude today's conference. Thank you all for participating. You may now disconnect. Have a great day.