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Edited Transcript of FTNT earnings conference call or presentation 27-Apr-17 10:30pm GMT

Thomson Reuters StreetEvents

Q1 2017 Fortinet Inc Earnings Call - Q&A Session

Sunnyvale Apr 30, 2017 (Thomson StreetEvents) -- Edited Transcript of Fortinet Inc earnings conference call or presentation Thursday, April 27, 2017 at 10:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Andrew H. Del Matto

Fortinet, Inc. - CFO

* Kelly Blough

* Ken Xie

Fortinet, Inc. - Founder, Chairman and CEO

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Conference Call Participants

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* Fatima Aslam Boolani

UBS Investment Bank, Research Division - Associate Director and Equity Research Associate Technology-Software

* Gabriela Borges

Goldman Sachs Group Inc., Research Division - Equity Analyst

* Gregg Steven Moskowitz

Cowen and Company, LLC, Research Division - MD and Senior Research Analyst

* Hendi Susanto

G. Research, LLC - Research Analyst

* James Fish

* John Alexander Lucia

JMP Securities LLC, Research Division - VP and Research Analyst

* Keith Frances Bachman

BMO Capital Markets Equity Research - MD and Senior Research Analyst

* Kenneth Richard Talanian

Evercore ISI, Research Division - Analyst

* Melissa A. Gorham

Morgan Stanley, Research Division - VP

* Saket Kalia

Barclays PLC, Research Division - Senior Analyst

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Presentation

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Operator [1]

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Good day, ladies and gentlemen, and welcome to the Fortinet First Quarter 2017 Financial Analyst Q&A Session. (Operator Instructions) I would now like to turn the call over to Kelly Blough, Vice President of Investor Relations. Please go ahead.

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Kelly Blough, [2]

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Hello, everyone, and thank you for dialing back in. I want to remind you before we begin that all of the statements I made earlier related to forward-looking statements and non-GAAP financial measures still apply to this call. GAAP and non-GAAP reconciliations can be found on our earnings press release. We encourage you to refer to the Investor website at www.investor.fortinet.com for important information, including our earnings release issued earlier today and the slides that accompanied the presentation earlier today and other important information about the company.

Now we'll take your questions. Thank you.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from Ken Talanian with Evercore ISI.

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Kenneth Richard Talanian, Evercore ISI, Research Division - Analyst [2]

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I know it's a little early, but I was wondering what impact, if any, the proposed tax reform might have on your business.

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Andrew H. Del Matto, Fortinet, Inc. - CFO [3]

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Yes, I -- Ken, I -- it is a bit early to see where that goes, because it -- I just -- I really don't have an answer for you, unfortunately. It's just too early. I mean, it's just coming out, really, yesterday, and so it's just a bit early. Obviously, a lower corporate tax grade is a favorable thing.

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Kenneth Richard Talanian, Evercore ISI, Research Division - Analyst [4]

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Understood, and obviously why I asked that. I guess as a follow-up. So there's been a lot of talk about the forthcoming EU regulation, GDPR, and whether it might have a benefit on security. Just I'm curious, what are your thoughts around the potential benefit to Fortinet? And what, if anything, are you doing around the marketing front to address that?

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Andrew H. Del Matto, Fortinet, Inc. - CFO [5]

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Yes, we are focused on it. It's starting to come out. I think it's going to be one of these things, it's probably more 2018, to be frank, in terms of the buying. We've learned a lot. It'd be interesting to see who the beneficiaries are. But broadly speaking, it's going to be companies -- countries that remain within the EU, let's say. And so I think Brexit will have an impact potentially on, for instance -- because the information will have to be located in an EU country. And we are focused on the marketing efforts around that, starting to get engaged, and looking where the likely opportunities are and starting to engage directly with where we think those opportunities are.

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Operator [6]

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Our next question is from Gregg Moskowitz with Cowen and Company.

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Gregg Steven Moskowitz, Cowen and Company, LLC, Research Division - MD and Senior Research Analyst [7]

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Okay. I apologize if this has been asked. It's been a busy evening in software. I guess, my first question is on the 8-figure deal, Drew, can you say what vertical NGO that was in? And then, also, was that a competitive one?

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Andrew H. Del Matto, Fortinet, Inc. - CFO [8]

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Sure. It was in the U.S. It was a competitive win. It was for a next-gen architecture that really goes -- will last quite a while. And it was a longer-term look, from the customer's perspective, architecturally. And then that was the other part of...

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Kelly Blough, [9]

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Universities, what...

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Andrew H. Del Matto, Fortinet, Inc. - CFO [10]

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Oh yes, it was education.

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Gregg Steven Moskowitz, Cowen and Company, LLC, Research Division - MD and Senior Research Analyst [11]

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Perfect. And then just for my follow-up, are you still expecting -- it sounds like it is the case for this year, but I wanted to confirm, still expecting, Drew, $140 million to $150 million for your CapEx for this year as well as next? And then, also, do you have any updated view on how long you anticipate this accelerated level of CapEx will last?

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Andrew H. Del Matto, Fortinet, Inc. - CFO [12]

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Yes, let me repeat it. So we are -- we're sticking to the $140 million to $150 million for 2017 for -- I don't believe we ever guided $140 million to $150 million beyond 2017. I believe what we said -- what we were trying to say was that the real estate investments could go on for quite a while. And at that -- 3 months ago, we were a little unsure of how those would roll out, because it has a lot to do with when you can buy, when you can build, and how you – planning, zoning and the various dimensions that go along with it. And we've gotten more clarity in that over the last 3 months. And so I think we said to expect elevated levels on the real estate side, and we said the real estate would be about $120 million this year, which is we're sticking with for '17. And then, just to be conservative and let people know that we were going to continue down the real estate path. We continued to say keep it at that level for the next couple of years. I -- because, really, we just didn't have a best -- better number. That's what we were saying. Now we think it'll be roughly half of that. And so maybe $120 million over '17 and -- or over '18 and '19, if you will. So not as elevated as we thought. Again, we're getting better visibility into how this might roll out. We're also in -- looking for the best opportunity for the company from a model perspective, an OpEx model perspective. And it's -- if real estate opportunities appear that are advantageous, then we're going to clearly look at those. But we're really trying to get to a phased approach and spread that out a little more, if you will, and just certainly buy as we need, buy or build as we need.

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Operator [13]

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Our next question is from Keith Bachman with Bank of Montréal.

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Keith Frances Bachman, BMO Capital Markets Equity Research - MD and Senior Research Analyst [14]

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I'm going to ask 2 questions, if I could, and thanks for the real estate question. So it sounds like $60 million may be elevated over and above a number in '18 and $60 million and above over whatever that number might be in '19, over and above, say, a normalized CapEx number. That's the way to think about it?

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Andrew H. Del Matto, Fortinet, Inc. - CFO [15]

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Yes. And again, without guiding, it's a little premature to guide CapEx for '18 and '19 because...

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Keith Frances Bachman, BMO Capital Markets Equity Research - MD and Senior Research Analyst [16]

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No, I'll -- yes, that's okay. I'll do a percent of revenue on CapEx. I'm just trying to figure out what my real estate -- I want to give you -- okay, go ahead.

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Andrew H. Del Matto, Fortinet, Inc. - CFO [17]

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I was just going to clarify something, because it sounded like you were going there. And if you think of this year being $140 million to $150 million in total CapEx, and we said around $120 million of real estate, I think that would give you a sense for what the other run rate CapEx is. You don't have to go beyond the model. And so I was just -- I just didn't want you to -- I thought it'd be important to have kind of a sense for what we -- the balance of what's north of $120 million would be more or less the number -- the run rate CapEx stuff.

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Keith Frances Bachman, BMO Capital Markets Equity Research - MD and Senior Research Analyst [18]

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Okay, great. And I will give you some unsolicited feedback. I think this is an area of concern about a company with 5,000 employees spending $200 million on real estate. It feels like a lot. So in the previous call, you said you'll listen to shareholders. I think I'm glad to hear you pare it back but encourage you to have additional conversations with shareholders about the real estate expenditures. The second question I wanted to ask, though, is the stock is off a decent amount here in the aftermarket. I think one of the things, at least we got e-mailed on, was that the mix between short term and long term was a little different than what investors were thinking. I think it's picking on a little bit of nothing candidly, but as you grow the subscription services, will that drive a little more over time into long-term deferreds? In other words, would that change your mix over time?

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Andrew H. Del Matto, Fortinet, Inc. - CFO [19]

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Well, I would start -- sure, I would say a couple of things. First of all, short-term deferred did grow 26% year-over-year. I would start with that. I'd say the answer, though, is yes, you do end up deferring more because the value of the higher-priced services are more. Therefore -- and that's the part that's recognized over time. And then, I think the other thing to keep in mind is that as we go deeper in the enterprise or broader in the enterprise, if you will, there tends to be -- customers obviously know that they'll get a better price there. There's discount, there's -- trading price for tenor matters. And so it's another way to get more value out of your security dollar. And I think enterprises are very tuned in to doing that, and I think that's true across our competitive landscape.

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Operator [20]

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Our next question is from Hendi Susanto with Gabelli and Company.

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Hendi Susanto, G. Research, LLC - Research Analyst [21]

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Ken and Drew, if I may, I would like to ask 2 questions. First, one basic question is for Ken. How do you characterize 2017 compared to 2016 market environment? What are your puts and takes? Do you expect 2017 to be a better year in terms of market demand and growth opportunities?

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Ken Xie, Fortinet, Inc. - Founder, Chairman and CEO [22]

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I think it's pretty same. I don't see much difference. Yes, I think we really like divide market by region, by vertical. There are some region probably not very stable, but overall, I think it's about the same. And also, the vertical, there's a little bit shift in from -- even for ourselves, we're starting a little bit more focused on enterprise and continue to gain share in the SMB. And then, the service provider probably take a little bit longer time to get SMB deal to close. But overall, I think it's similar. I don't see much difference.

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Hendi Susanto, G. Research, LLC - Research Analyst [23]

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Got it. And then, one question for Drew. Not too long ago, in the third quarter 2016, Fortinet reported sales execution challenges in North America enterprise because of the new sales structure. Is that fully behind the company? And what is the state of your sales organization now in terms of productivity?

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Andrew H. Del Matto, Fortinet, Inc. - CFO [24]

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Sure. Our model adjustments we really made over the last year are working. We've shown good progress and we continue to show good progress on productivity. We feel that, that's in a good state. We're very model-focused on productivity and getting direct touch, if you will, with our customers from our sales force. Obviously, we have an indirect model, but we increasingly support that with direct touch from our sales force and building that out. All of that, along with the flat organization, gives us more insight into what they're doing on a day-to-day basis and very focused. And we think all of that is the model that we'll see going forward and what's been working well in the past.

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Hendi Susanto, G. Research, LLC - Research Analyst [25]

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And if -- Drew, if I may clarify, so you still have some significant upside in terms of your sales productivity?

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Andrew H. Del Matto, Fortinet, Inc. - CFO [26]

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Well, I think they've made good progress and I think they should continue to make good progress.

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Operator [27]

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Our next question is from Gabriela Borges with Goldman Sachs.

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Gabriela Borges, Goldman Sachs Group Inc., Research Division - Equity Analyst [28]

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Great. Maybe just a little bit more on the non-FortiGate products that sold well in the quarter. And if you could spell it out for us, the Security Fabric that you have, given that it's open API and that you can roll up some of the information from the other security products in your environment into that architecture, does that help you with the cross-sell opportunity at all? Or does it give you better visibility into maybe areas where you could improve the depth of engagement of customers?

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Ken Xie, Fortinet, Inc. - Founder, Chairman and CEO [29]

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I think the fabric, like I say, the -- including the network and firewall product in the middle, but also there is a -- from Endpoint side, FortiClient, and then there's an access, mostly WiFi, FortiAP. Then there's also, we have FortiMail product, FortiWeb, and also the cloud offer. Also, some IoT (inaudible) I think, all this working together, like -- that's where -- when we starting promote a fabric. Because in the past, the most business come from the FortiCare. Now the fabric -- and if the sales can very -- sales and the engineer can very making this working, they can easily double, triple the deal size because the other product working together. And also, we're using the one fabric, our managed platform, to manage all this together. So that's what increased the help in -- especially on a lot of existing customer base to increase the deal size and also helping a lot on the cross-sell, upsell there. The detail number, we'll probably consider to release maybe in the next few quarters, something like that. But I think it's starting grow faster than the FortiGate right now.

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Gabriela Borges, Goldman Sachs Group Inc., Research Division - Equity Analyst [30]

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That's helpful. And Drew, one follow-up on the comment that the company's doing more ahead of ASC 606. Maybe just some color on how you guys are preparing for that, and what you think -- early days I know, but what you think that could look like in terms of how product is recognized, one form or other, and [stuff]?

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Andrew H. Del Matto, Fortinet, Inc. - CFO [31]

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I'll do my best, Gabriela. It's still early. We -- again, we have -- we deliver value over time to the customers, and I don't believe that significantly changing in terms of how the revenue's accounted for as long as you're delivering value over time. So we haven't completed the assessment, so I probably wouldn't want to go beyond that.

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Operator [32]

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Our next question is from Walter Pritchard with Citigroup.

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James Fish, [33]

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It's Jim Fish on for Walter. Just 2 quick ones. First, on the 22% target model, what is the major source of leverage in OpEx? As typically, when we hear these types of targets, we get sort of a breakdown in terms of percentage of revenue. And then, secondly, what are you seeing from AccelOps so far versus your expectations? As I'm just trying to understand what kind of impact it had on the quarter as well.

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Andrew H. Del Matto, Fortinet, Inc. - CFO [34]

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So the first question was you're just talking about the margin ramp and how we're getting to the longer-term guidance? Just to be clear? You were looking for more...

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James Fish, [35]

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Yes, I mean, typically, when you get these longer-term models, you're being given sort of what you guys are expecting between the OpEx lines, just on a percentage of revenue basis. Just looking for some thoughts. I know you're not giving it out, but how are you -- trying to get qualitatively how you're getting there.

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Andrew H. Del Matto, Fortinet, Inc. - CFO [36]

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Yes, sure. I -- look, I would say, over the long term, we should see benefits -- I would go back to what we said. I -- we weren't giving out specific by line, but I could give you some generalities that hopefully are helpful. And you could see that we've trended up on the gross margin line, and we've broken out the services line versus the product line. And I think, as that mix shifts more towards services, you'll see the benefit there. And so as you run your models, that'll probably -- I think you can see some trajectory there. The next piece of this and -- it has really come from the sales and marketing side. And you’ve seen we've creeped up into the mid-40s. Clearly, you're going to get a number in the long-term model that has a 3 in front of it on sales and marketing. The ramp, I wouldn't give you specifics year by year, but clearly, that's the target of where we feel we're going to get the bulk of the benefit, the improvement on the operating model.

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James Fish, [37]

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Got it. And then on AccelOps, sort of how is it doing versus your expectations? And any impact it had on the quarter?

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Andrew H. Del Matto, Fortinet, Inc. - CFO [38]

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Yes, I -- look, it's -- I would say, right now, it's a minor impact in terms of revenue. Keep in mind the revenue on that front is actually ratable. The deployments, it's entering a -- it's a fairly lengthy sales cycle because you have to go through tough deployments and some testing, but it seems to be resonating well as part of the fabric.

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Operator [39]

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Our next question is from Fatima Boolani with UBS.

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Fatima Aslam Boolani, UBS Investment Bank, Research Division - Associate Director and Equity Research Associate Technology-Software [40]

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Drew, maybe Ken, a question for you, Meru's now been folded into the company for 2 years -- just about 2 years. Can you touch it on the broader WiFi opportunity, just kind of from the E-Rate perspective? And as well as that $12 million deal you did in the educational vertical, curious if that had -- if the Meru-based technology had any input or impact in there.

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Andrew H. Del Matto, Fortinet, Inc. - CFO [41]

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Well, I'll take the last part. No, there wasn't -- we don't typically share I think what goes to the customers, but I don't believe there was a wireless in that offering -- in that opportunity. But Ken, you -- maybe you could answer?

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Ken Xie, Fortinet, Inc. - Founder, Chairman and CEO [42]

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Yes. I think, the Meru, we're still in the transition from their more like -- or WiFi. We are using the FortiGate security gateway as a controller like a managed WiFi with security together. So we're still in the transition as try to convert the old WiFi into WiFi plus security together. So that's still going on, because some of the product, like we said, may take like a few years to gradually transition into the new product. So that's process still going on. And other than that, we see -- there's very strong feedback from customers. They don't see the value of security and WiFi need to be managed together, but it's -- that process still may take additional 1 to 2 years.

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Fatima Aslam Boolani, UBS Investment Bank, Research Division - Associate Director and Equity Research Associate Technology-Software [43]

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Great. And a quick one on sales force incentive. I'm curious if there has been any substantial changes to incentives, incentive structures, especially as you've kind of moved more aggressively into the enterprise vertical. Just really trying to pin down on what's really rehabilitated that productivity. That'd be helpful.

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Andrew H. Del Matto, Fortinet, Inc. - CFO [44]

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We think the 2 primary driver -- I mean, really, it's getting enterprise people with experience, and then I think in a related industry close to our networking/security industry. I think that's key -- that's been the key component. Training is the next thing. We've invested heavily in training and training them on the fabric. We feel like that's been very successful. And then just giving people time in the seat and time with the company and time with their customers, that's helped a lot. So it's really those factors. The people, the training, getting them up to speed on our value proposition, the value proposition of the fabric and helping them -- enabling them to articulate that to the customers and just giving them time to close their transactions.

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Fatima Aslam Boolani, UBS Investment Bank, Research Division - Associate Director and Equity Research Associate Technology-Software [45]

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Drew, can I just clarify something very quickly? You said there will be about $120 million in real estate-related CapEx dribbling into '18 and '19 and the levels thereafter will stay elevated. I just wanted to clarify your comment and make sure I understood that correctly.

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Andrew H. Del Matto, Fortinet, Inc. - CFO [46]

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So are you asking about '18 and '19?

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Fatima Aslam Boolani, UBS Investment Bank, Research Division - Associate Director and Equity Research Associate Technology-Software [47]

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Yes. I understood that there is $120 million split over '18 and '19 associated with real estate investments?

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Andrew H. Del Matto, Fortinet, Inc. - CFO [48]

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Yes, that's correct.

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Fatima Aslam Boolani, UBS Investment Bank, Research Division - Associate Director and Equity Research Associate Technology-Software [49]

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And the level would be elevated thereafter as well. Is that a correct interpretation?

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Andrew H. Del Matto, Fortinet, Inc. - CFO [50]

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Your second part of thereafter. I just want to make sure I'm asking you. So the answer for '18 and '19, correct, and we haven't really addressed thereafter.

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Operator [51]

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Our next question is from Melissa Gorham with Morgan Stanley.

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Melissa A. Gorham, Morgan Stanley, Research Division - VP [52]

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Great. I just have a question on capital allocation. So Drew, in '16, you did buy back stock. This quarter, it looks like you didn't buy any. You have the cash, and it seems like you have the authorization, some capacity and the buyback authorization. So just wondering, your philosophy on use of cash and what we should expect for buybacks moving forward.

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Andrew H. Del Matto, Fortinet, Inc. - CFO [53]

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Right. Yes, so I think use of cash, again, capital allocation -- capital strategy is, one, obviously, is to grow the company. So to the extent that something inorganic makes sense, we'll continue to evaluate and consider those opportunities. I have nothing to mention along that line right now. In terms of buyback, that's correct, we didn't buy back any shares last quarter. We did -- just so you know, we did have a program in place -- through a 10b5-1 we put in place. It just -- it didn't pick up any shares, if you will. And so as we go forward, we don't really comment about the levels at which we'll buy back, but we're certainly focused on the buyback. I know there's $189 million left, and we'll revisit the levels that we're buying back going forward. And just -- I was just going to clarify, Melissa, there have been some quarters in the past where we get a lot and some we don't get much, if any.

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Operator [54]

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Our next question is from Erik Suppiger with JMP Securities.

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John Alexander Lucia, JMP Securities LLC, Research Division - VP and Research Analyst [55]

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This is John Lucia on for Erik again. I just wanted to circle back to ask about attrition again based on the headcount addition metrics. Can you just tell us if attrition has increased, decreased or remained in line over the last year, or give us any metrics that would help us on that front?

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Ken Xie, Fortinet, Inc. - Founder, Chairman and CEO [56]

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I think we have below-industry-average attrition, and I don't see much difference. I think that we also -- we're more like a careful hiring -- evaluated new hiring. That's probably make the headcount growth a little bit slower compared to like a couple years ago. But I don't see much change on the attrition rate there.

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John Alexander Lucia, JMP Securities LLC, Research Division - VP and Research Analyst [57]

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Okay, that's helpful. And then, I was wondering what you guys are seeing on the opportunity for internal segmenting with firewalls. Have you seen any momentum on that front? Or can you tell us how far you are from generating material billings from that opportunity?

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Ken Xie, Fortinet, Inc. - Founder, Chairman and CEO [58]

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Yes, that's the internal segmentation is the marketing message we launched about 2 years ago. We do see a big enterprise keeping this as a new approach to address their internal security issue. But now we believe the fabric probably works better, because not only the internal but a lot of data also go to mobile, go to the cloud. So that’s using the full fabric approach probably can kind of more address the whole infrastructure. I think internal segmentation is a much better approach compared to like some single -- I mean, some firewall just control the internet access part. That's also -- in a data center side, internal segmentation also works quite well, both as a cloud provider and also some like co-location data center there. But on the other side, for some enterprise, we're thinking that we also see some good feedback as the whole fabric approach is a more efficient and better security compared to the single firewall, the internal segmentation.

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John Alexander Lucia, JMP Securities LLC, Research Division - VP and Research Analyst [59]

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Okay. And my last question is, there's been a lot of talk about the non-FortiGate products. Can you just tell us which non-FortiGate products have exceeded your expectations or maybe surprised you in the last quarter or so? Anything on particular products or services that have surprised you or that are doing particularly well.

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Andrew H. Del Matto, Fortinet, Inc. - CFO [60]

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Sure, a little bit. I think the FortiClient, FortiMail, sandbox, FortiSandbox, FortiSwitch. They're the ones.

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Ken Xie, Fortinet, Inc. - Founder, Chairman and CEO [61]

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FortiWeb also.

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Andrew H. Del Matto, Fortinet, Inc. - CFO [62]

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FortiWeb also. Yes.

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Ken Xie, Fortinet, Inc. - Founder, Chairman and CEO [63]

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Yes. That's where basically the e-mail security starting doing well, and also the web security. And we do have Endpoint in there like more than 10 years starting to see some good ramp-up now, because also some mobile solution also working well. And then the -- I think the WiFi access is also starting to show some more interest growth.

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Operator [64]

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Our next question is from Saket Kalia with Barclays Capital.

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Saket Kalia, Barclays PLC, Research Division - Senior Analyst [65]

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So Drew, not to beat a dead horse, just to go back to the long-term model. I guess, I kind of want to ask a little bit about the top line without just expressly asking for the growth number. I mean, can you just talk about your assumptions around market share gains in FortiGate through the long term? I mean, do you assume that FortiGate eventually normalizes to sort of market rate of network security? Or do we assume kind of continued share gain? Maybe the other piece of this -- can you talk about non -- the non-FortiGate business in terms of mix as part of that long-term model?

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Andrew H. Del Matto, Fortinet, Inc. - CFO [66]

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Yes. Saket, we're not guiding revenue longer term.

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Saket Kalia, Barclays PLC, Research Division - Senior Analyst [67]

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Sure. Well, maybe qualitatively. I mean, is -- are we assuming that FortiGate continues to be a share gainer? (inaudible)

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Andrew H. Del Matto, Fortinet, Inc. - CFO [68]

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Well, I mean, if you -- I think if you compare the guidance we gave for the -- for '17 and for Q2, those would imply share gain.

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Operator [69]

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And I'm showing no further questions. I would now like to turn the call back over to Kelly Blough for any further remarks.

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Kelly Blough, [70]

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Thanks, everyone, for taking the time to call in again. We look forward to talking to you throughout the quarter.

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Operator [71]

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Thank you. Ladies and gentlemen, thank you for participating in today's conference. You may all disconnect. Everyone, have a great day.