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Edited Transcript of FTNT earnings conference call or presentation 27-Apr-17 8:30pm GMT

Thomson Reuters StreetEvents

Q1 2017 Fortinet Inc Earnings Call

Sunnyvale Aug 12, 2017 (Thomson StreetEvents) -- Edited Transcript of Fortinet Inc earnings conference call or presentation Thursday, April 27, 2017 at 8:30:00pm 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 & CEO

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Conference Call Participants

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* Andrew James Nowinski

Piper Jaffray Companies, Research Division - Principal and Senior Research Analyst

* Catharine Anne Trebnick

Dougherty & Company LLC, Research Division - VP and Senior Research Analyst

* 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

* Jayson Noland

Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst

* John Alexander Lucia

JMP Securities LLC, Research Division - VP and Research Analyst

* Kenneth Richard Talanian

Evercore ISI, Research Division - Analyst

* Melissa A. Gorham

Morgan Stanley, Research Division - VP

* Michael Feldman

BofA Merrill Lynch, Research Division - Research Analyst

* Michael Turits

Raymond James & Associates, Inc., Research Division - MD of Equity Research and Infrastructure Software Analyst

* Patrick Colville

Arete Research Services LLP - Analyst

* Robbie David Owens

Pacific Crest Securities, Inc., Research Division - Partner and Senior Research Analyst of Security and Infrastructure Software

* Saket Kalia

Barclays PLC, Research Division - Senior Analyst

* Shaul Eyal

Oppenheimer & Co. Inc., Research Division - MD and Senior Analyst

* Sterling Auty

JP Morgan Chase & Co, Research Division - Senior Analyst

* Walter H Pritchard

Citigroup Inc, Research Division - MD and U.S. Software 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 First Quarter 2017 Fortinet Earnings Conference Call. (Operator Instructions) As a reminder, this call is being recorded.

I would now like to introduce your host for today's conference, Ms. Kelly Blough, Vice President of Investor Relations. Ma'am, you may begin.

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Kelly Blough, [2]

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Thank you, operator, and thanks to everyone on the call for joining us on this busy afternoon to discuss Fortinet's financial results for the first quarter of 2017.

With me today are Ken Xie, Fortinet's Founder, Chairman and CEO; and Drew Del Matto, CFO. Ken will begin our call by providing a high-level perspective on our business. Drew will then review our financial and operating results and conclude with our forward guidance outlook before opening up the call for questions. (Operator Instructions)

For those who have additional questions, we will be holding a second conference call at 3:30 p.m. Pacific Time. Both calls will be webcast from our Investor Relations website.

Before we begin, I'd like to remind you that on the call today, we will be making forward-looking statements. These forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those projected in these statements.

Please refer to our SEC filings, in particular the risk factors in our most recent Forms 10-K and Forms 10-Q for more information. All forward-looking statements reflect our opinions only as of the date of this presentation, and we undertake no obligation and specifically disclaim any obligation to update forward-looking statements.

Also, please note that we will be discussing certain non-GAAP financial measures on this call. Our GAAP results and GAAP to non-GAAP reconciliations can be found in our earnings press release and on Slides 11 and 12 of the presentation that accompanies today's call.

We also encourage you to refer to the Investor Relations section of our website at investor.fortinet.com for important information, including our earnings press release issued a few minutes ago, the slides that accompany today's prepared remarks, and other important information about the company.

A replay of this call will also be available on our website.

I'll now turn the call over to Ken.

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Ken Xie, Fortinet, Inc. - Founder, Chairman & CEO [3]

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Thank you, Kelly, and thanks to everyone joining today's call to discuss our first quarter 2017 results. In the first quarter, Fortinet delivered a billing and revenue growth that exceeded our guidance and continue to surpass the market growth rate. We continue to improve our profitability, and as we have discussed in the past, we plan to steadily increase our operational margin to create additional value for our shareholders.

In the first quarter, we saw strength in the large multi-product deals, demonstrating that our Security Fabric architecture is continuing to gain mind share and market share for Fortinet. Our customer and partners recommend that our competitor's multi-point product's loosely integrated solution do not provide the breadth, depth, performance and orchestration needed to address the demand of today's digital economy.

The Fortinet Security Fabric is coercive, multiproduct platform that works together to detect, monitor, log and remediate attacks against entire enterprise service area, responding to our customers' need for seamless highly integrated approach to security that protects all points in the network.

Enterprise do not have to sacrifice their network performance to ensure that their networks are secure in this highly competitive and evolving landscape. Our latest next-generation of firewall, the FortiGate 7000 Series with the 7030E, 7040E, 7060E deliver ultrahigh speed next-generation of firewall and Advanced Threat Protection in a flexible chassis-based form factor based on the latest CP9 security processor.

Many security vendors detect threats, some prevent them with innovative solutions but only Fortinet excel in all 5 stages of network security: Detection, prevention, integration, performance and value. As we continue to learn and expand into some of the largest enterprise corporations and [organizations] in the world, we again added more than 10,000 new customers during the quarter.

This brings our total to more than 310,000 customers worldwide. Broader adoption of the Security Fabric also result in increased the sales in the quarter of non-FortiGate solutions.

During the quarter, we are pleased to announce that several leading technology companies joined the Fortinet Security Fabric-Ready ecosystem including Cisco, Hewlett-Packard, Nuage Networks from Nokia and more. To date, Fortinet has 22 fabric-ready program partners, representing a cross-section of leading information technology providers whose offerings tightly integrate with the Fortinet Security Fabric.

This open approach enable multiple vendors' security solutions to share actionable threat intelligence and mitigation information in real time. We're also pleased to announce early this month that Fortinet has extended the core capability of our Security Fabric architecture to enable business to experience the same level of cybersecurity and threat intelligence in cloud environment as they do in their physical networks.

The latest enhancement of the FortiOS 5.6 offer customers the ability to manage security capabilities across their private, public cloud and a software-defined wide area network as the WAN environment.

Early this month, Fortinet and Vodafone announced a new global relationship to provide the next-generation security solutions to enterprise customer by embedding Fortinet's high-performance virtualized secure solution and an integral security fabric architecture within Vodafone's core network products.

Our strength in the cloud offering is driving demand for on-premise implementation of the Fortinet Security Fabric. By providing the highest performance, most complete and well-integrated solutions, the Fortinet Security Fabric has positioned Fortinet as an innovator and the market leader.

I will now turn the call to Drew to review our first quarter financial results and following guidance.

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Andrew H. Del Matto, Fortinet, Inc. - CFO [4]

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Thank you, Ken. Now let me share our financial results for the first quarter, which can be seen on Slide 3.

Fortinet had a strong start to 2017 with billings and revenue exceeding the high end of our guidance ranges. Billings increased 22% year-over-year to $403 million. Reflected in this number is approximately $12 million from a single deal closed in the quarter. Approximately 70% of the revenue from the [Small D] year contract was deferred into future periods.

Revenue of $341 million was up 20% year-over-year. Revenue growth was driven by strong performance in North America, particularly in enterprise, demonstrating ongoing improvement in sales productivity.

As Ken mentioned, we saw success in large deals and in multiple product deployments, demonstrating adoption of the Fortinet Security Fabric. Deferred revenue grew strongly again to $1,098,000,000, up 31% year-over-year, reflecting the business shift to more margin-rich recurring subscription and service revenue.

Sales of enterprise bundles were again strong in the first quarter, driving higher-priced and higher-margin recurring revenue over time. Our non-GAAP gross margin was 75%. Our strategic focus on driving sales of higher-value, higher-price and higher-margin recurring revenue streams, such as services and virtualized product offerings, contributed to our improved gross margin in the quarter.

Non-GAAP operating margin was 13% and non-GAAP earnings per share were $0.17. Finally, we generated $116 million of free cash flow during the quarter, an increase of 65% over the first quarter of 2016. Our first quarter results benefited from customers' recognition of the value, performance and comprehensive security coverage provided by Fortinet's Security Fabric. This was evidenced in the first quarter by continuing strength in large multiproduct deals and sales of non-FortiGate products to enterprises.

The number of deals over $100,000 grew 20%, deals over $250,000 grew 15% and deals over $500,000 grew 31%. The majority of our large deals were attributable to the key differentiators of the fabric, particularly manageability, orchestration and integration across the enterprise. For example, in the aforementioned multimillion-dollar multiproduct contract with a large educational institution, Fortinet's technology beat out the incumbent and other competitors not only due to performance, but also to the manageability and integration capabilities that the Fabric provides.

In another first quarter deal, Fortinet is being deployed in a large European financial institution whose incumbent security solution was not scalable, powerful or manageable enough to respond to its growing business and larger attack footprint. The customer chose Fortinet Security Fabric for our ability to provide internal segmentation and advanced threat protection in the context of a scalable, well-orchestrated, high-performance solution.

Cloud solutions are a critical component of the Fortinet Security Fabric and represent a significant expansion opportunity and long-term driver of our growth. Fortinet delivers security to the cloud and for the cloud, the latest enhancements to the FortiOS enable customers to manage security capabilities across their cloud assets and software-defined wireless access networks.

We also announced this month the launch of FortiCASB, a cloud access security brokerage providing customers and partners with an interface to gain visibility and control of their SaaS applications through the Fortinet Security Fabric.

Turning to our quarterly sales results. The breakdown of billings across our top 5 verticals was: Service provider at 21%; government at 15%; education at 13%; financial services at 11%; and retail at 9%.

On a geographic basis, billings in the Americas grew 27%, led by the United States, which outpaced all other regions in the first quarter, validating the changes that we made to our substructure just a year ago. EMEA billings grew 17% and APAC billings grew 22%.

Now turning to billings by product portfolio on Slide 4. High-end products accounted for 36% of total product billings, our midrange products accounted for 31% and our entry-level products accounted for 33%.

Revenue was $341 million in the quarter, up 20% year-over-year. As you could see on Slide 5, revenue performance was driven by the combination of 9% year-over-year product revenue growth and 28% year-over-year services revenue growth.

The continued shift to higher services growth reflects our ongoing success in driving higher-priced subscription bundles, meter-modeled business and virtual solutions.

On a geographic basis, from a revenue standpoint, you could see on Slides 6 and 7 that revenue continues to be diversified globally, which remains a key strength of our business.

Revenue from the Americas represented 43% of our business and grew 22% year-over-year. Revenue from EMEA represented 37% of our business and grew 20% year-over-year. And revenue from APAC represented 20% of our business and grew 15% year-over-year.

During the first quarter, our non-GAAP gross margin was 75%. Non-GAAP services gross margin was 84%. Non-GAAP product gross margin was 60%. We continue to focus on productivity and efficiency in our operating model, paying close attention to the growth in billings versus operating expenses.

On a year-over-year basis in the first quarter, billings grew by 22%, while sales and marketing expense grew just -- by just 16%. As expected, general and administrative expenses were elevated in the first quarter, due in part to preparations for our implementation of the new revenue accounting standard.

In all, year-over-year, we had $73 million of incremental billings on just $31 million in incremental operating expense. As a percentage of revenue on a non-GAAP basis, sales and marketing expenses were 44%, down from 46% in the first quarter of last year. Research and development expenses were 13%, flat with last year. And general and administrative expenses were 5%, also flat with last year.

Total non-GAAP operating expenses were $211 million during the first quarter, resulting in non-GAAP operating income of $43 million or 13% of total revenue, up 200 basis points year-over-year.

Non-GAAP net income for the first quarter was $31 million or $0.17 per share, based on approximately 178 million diluted shares outstanding.

As expected, the annualized non-GAAP tax rate declined to 32%. As seen on Slides 8 and 9, we ended the first quarter with a strong balance sheet, including $1,444,000,000 in cash and investments.

Free cash flow in the quarter was $116 million, an increase of 65% over the first quarter of 2016. Annualized inventory turns for Q1 were 1.6. Inventory turns were lower than expected in the first quarter due to early receipt of $8 million of inventory that was scheduled for Q2 delivery, and due to a ramp in inventory for our transition from the D to E series of appliances.

We expect to normalize our or inventory turns to 2 or better over the next several quarters. Deferred revenue increased to $1,098,000,000, an increase of $261 million or 31% year-over-year. DSO was 71 days.

Before I discuss guidance for the second quarter, I want to provide an update on our real estate plans. As I mentioned on our fourth quarter call, we are addressing our facilities requirements over the next several years, both at headquarters in California as well as in Vancouver.

At the beginning of the year, we guided $140 million to $150 million in CapEx for 2017, including approximately $120 million on real estate. Earlier this month, we concluded the purchase of the Vancouver building, so the vast majority of the real estate CapEx for 2017 will occur in the second quarter, affecting our Q2 free cash flow. We expect to return to strong free cash flow generation in the second half of the year.

Let me now finish with our guidance for the second quarter and updates to our previously issued guidance for the full year, which can be seen on Slide 10.

I will also address our plans for longer-term operating margin expansion. As a reminder, all forward-looking statements, including all the guidance statements provided are subject to Kelly's cautions at the start of this call.

Fortinet's market opportunity and competitive advantage is significant. Our investments have helped lay the foundation for our future growth, share gains, increasing profitability and shareholder value creation.

As I've mentioned, our model is shifting toward more margin-rich services revenue, which tends to have a higher ratio of deferral. These factors, along with the typical seasonality of the business and our expense structure, are carefully factored into our near-term outlook.

For the second quarter of 2017, we expect billings in the range of $425 million to $432 million; revenue in the range of $357 million to $363 million; non-GAAP gross margin of 74% to 75%; non-GAAP operating margin of 14% to 15%; and non-GAAP earnings per share of $0.19 to $0.20.

We are updating our guidance for the full year 2017 to reflect the first quarter's performance. For 2017, we now expect billings in the range of $1,770,000,000 to $1,792,000,000; revenue in the range of $1,485,000,000 to $1,495,000,000; non-GAAP gross margin of 74% to 75%; and non-GAAP earnings per share of $0.89 to $0.91.

We had approximately $2 million of overachievement in non-GAAP operating income in the first quarter, which equates to approximately 10 to 20 basis points of operating margin on the full year at the middle of the range. We are adding that to our non-GAAP operating margin expectation for the year.

I'd like to conclude with some commentary on our longer-term operating model. As you know, over the last couple of years, Fortinet has carefully considered our investment strategy to find an appropriate balance between high revenue growth and profitability. We make critical investments in sales and marketing to broaden our go-to-market capabilities and focus on driving higher-margin recurring revenue streams.

In 2016, these efforts delivered non-GAAP operating margin improvements of approximately 200 basis points, exceeding our operating margin guidance, despite the dilution from the acquisition of AccelOps. We remain focused on driving higher sales productivity and maintaining a flat organization. We also have made a number of model and productivity improvements and changes to our operating structure to increase profitability.

As our Q1 results illustrate, we are seeing the benefits of our focused efforts and strategy. We meet with shareholders frequently and have heard from many of you that you would like more clarity and definition related to our path to operating margin improvement. In response to this feedback and recognizing the importance of increased profitability to our business and our shareholders, we are updating our margin targets as well as the milestones we expect to achieve to get there.

We plan to add 150 to 200 basis points to operating margins each year following 2017, reaching a minimum non-GAAP operating margin of 25% by 2022 and remaining thereafter in the 25% to 30% range. We appreciate our shareholders' feedback, and we welcome an ongoing dialogue with you on how to improve our business and increase shareholder value.

Now I'll hand the call back to Ken to close.

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Ken Xie, Fortinet, Inc. - Founder, Chairman & CEO [5]

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Thank you, Drew. We are very pleased with the first quarter result and with the progress that Fortinet is making. The Fortinet Security Fabric is winning in the marketplace, and we are gaining market share against our competitors. We believe the long-term operational model that Drew just outlined will bring the best value to our shareholders.

Our first quarter result illustrates that our strategy to expand our operating margin is working, and we believe our model will continue to offer improved profitability and value to our shareholders, while allowing Fortinet to remain an industry leader.

In closing, I would like to thank Fortinet's employees, partners, customers and shareholders for their continued confidence and support.

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Kelly Blough, [6]

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Operator, you may now start the Q&A.

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Questions and Answers

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Operator [1]

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(Operator Instructions) And our first question comes from Gabriela Borges with Goldman Sachs.

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Gabriela Borges, Goldman Sachs Group Inc., Research Division - Equity Analyst [2]

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Maybe I'll pick up right where the prepared remarks left off on the new operating model. To Ken, maybe you could just comment on how you arrived at that 25%-plus target in the 2022 time frame and how you think about what the right level of revenue growth will be, as you progress from where you are now today to that 25% level?

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

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Sure, Gabriela. Yes, I think, we're -- first of all, historically, I think, a while back, we were in the mid-20s. And we felt like we could get back there. And if we look around the industry, we thought that was closer to a longer-term benchmark that made sense for us. We know where we've made the investments, and I think we've been saying all along that we like the flat model and the changes that we've made over the last year and they appear to be working. And so I think now, the kind of stage 2 of that is really the path into drive higher productivity and operating margins over the next years. As far as revenue growth, I mean, without getting into that, we continue to want to take share. We believe our model supports doing that. Historically, we've done that and we think we can do that, while also expanding margins at the same time.

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Ken Xie, Fortinet, Inc. - Founder, Chairman & CEO [4]

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Also the Security Fabric story also starting to enhance the sales -- I mean, for the cross-sell, for the upsell opportunity. And also, we see the security -- the SPU, the security processor, also starting -- has a lot of advantage over competitors. That all can help in keeping expanding the margin and also help increase the growth.

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Operator [5]

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Our next question comes from Melissa Gorham with Morgan Stanley.

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Melissa A. Gorham, Morgan Stanley, Research Division - VP [6]

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I would want to maybe start with the deal that you mentioned at the beginning, Drew. I think, it was a $12 million deal. And I'm wondering if you can maybe just provide a little bit more color, as it seems pretty significant for you all. Is there anything that you can talk about in terms of whether it was a competitive displacement? And is it fair to assume that, that was a multiyear deal and was that embedded in your expectations coming into Q1?

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Andrew H. Del Matto, Fortinet, Inc. - CFO [7]

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Well, it was a competitive win. And the customer was really looking for a long-term model in their next-generation architecture over the next, say, 5 to 10 years, and it was a competitive placement. The fabric were the keys -- the fabric and performance were the keys to winning it. And yes, it was a longer -- it was a multiyear deal. What else did you ask, I'm sorry?

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Melissa A. Gorham, Morgan Stanley, Research Division - VP [8]

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Was this embedded in your expectations when you were guiding Q1, this deal?

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Andrew H. Del Matto, Fortinet, Inc. - CFO [9]

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We take a variety of factors into account for the forecast. To the extent that's in the funnel, then it's weighted into the forecast decision.

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Melissa A. Gorham, Morgan Stanley, Research Division - VP [10]

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Okay. Got it. And then, just one quick one on the operating margin guide. So for FY '17, you're still looking for about 100 basis points year-over-year improvement, but it seems like the full -- the longer-term guide is looking for a little bit more of an improvement after FY '17. So I'm just wondering why the modest operating margin improvement in FY '17? Is that just conservatism or is there some other factor to take into consideration?

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Andrew H. Del Matto, Fortinet, Inc. - CFO [11]

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Well, we -- actually, we picked up a little bit this quarter. I think, we left in the table 16% for rounding, but we picked up about $2 million that we're going to give back -- that will go back into the margin improvement for the year. I think it's just 10 to 20 basis points, I think, that -- we have a paragraph on that in the script, if you will. So we wanted to give the overperformance back. The other thing weighting, if you add that to the $10 million for the revenue implementation, I think, you get fairly close to 200 basis points for the year.

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Operator [12]

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Our next question comes from Sterling Auty with JPMorgan.

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Sterling Auty, JP Morgan Chase & Co, Research Division - Senior Analyst [13]

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I want to actually ask about competitive landscape. I apologize, I missed the first few minutes of the call, if you did comment. But given all the news coming out of the various vendors in the quarter, et cetera, what are you seeing in terms of the competitive landscape? Anybody getting weaker? Anybody getting stronger? Any changes in who you're seeing, in that kind of final shortlist in deals?

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Ken Xie, Fortinet, Inc. - Founder, Chairman & CEO [14]

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Sterling, this is Ken. I think, the big environment, we don't see much change compared with the last 2 years. And there's certain vertical space like some bigger provider or carrier, they probably spend more time to planning, some [aren't certain of whether to] transition to some cloud, some other service offering model. Other part, whether the enterprise, SMB, we do see pretty strong and also the new product we offered in the E model starting to ramp up pretty quickly also help. On the competitor side, I don't see much changed. We started promoting we call the Security Fabric. We have a pretty broad, probably broader than other competitor on the product portfolio here, not just network security but also the other parts, like from end point to the access part, to the application like Web and email security and into the cloud. We have quite a broad offering. So the fabric started really help and compete better compared to other competitors. So other than that, I see the whole environment hurting no more.

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

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Yes, and Sterling, it's Drew. I would just summarize that. I think the consolidation theme remains profound out there. And the fabric is clearly resonating, and you know the larger deals we do, it's a common theme. And that -- I think that's very consistent with what we saw in Q4 and consistent with what we'll see going forward.

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Ken Xie, Fortinet, Inc. - Founder, Chairman & CEO [16]

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Yes, I think, some like -- we also improve in the sales productivity like by 2 points compared to 1 year ago from 46% or 44%.

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

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I think you're talking as a percent of revenue.

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Ken Xie, Fortinet, Inc. - Founder, Chairman & CEO [18]

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As a percent of the revenue.

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

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Yes, but productivity was good, too.

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Sterling Auty, JP Morgan Chase & Co, Research Division - Senior Analyst [20]

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And then, just 1 follow-up, how would you answer -- one question that I get on a frequent basis is, okay, as we look at the shift to the cloud, moving to these virtual environments. Fortinet has long been known for having your custom ASIC and it gives you performance advantages, et cetera. How does Fortinet then compete in the world of AWS and Azure and public cloud providers in that situation?

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Ken Xie, Fortinet, Inc. - Founder, Chairman & CEO [21]

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Like in my script, we mentioned about we offer the best cloud and also together with the on-premise solution. So the cloud is starting to generate a lot of interest. They grow fast but on a pretty small base right now. On the other side, customers also evaluate -- cloud gives them some flexibility but don't have to -- I mean, saving the cost or maybe even increase the certain risk because you have access to data in the cloud and also, have to increase the bandwidth to access the cloud. So there's always a certain balance point, and whether using some cloud, also using some on-premise, that's where the hybrid solution probably will be the best. So a customer can change in their, like, a balance point based on their need at certain points. So I think cloud offers certain flexibility, but there's other part that need to be considered. So that's -- I believe, the vendor side, they need to offer both. And if only 1 part of it, it's more difficult to meet the customer demand.

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Andrew H. Del Matto, Fortinet, Inc. - CFO [22]

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And it's also -- right now, it's helping pull through on-premise for us as well, Sterling.

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Ken Xie, Fortinet, Inc. - Founder, Chairman & CEO [23]

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Also the new security processor also being used by the -- a lot of cloud provider service provider because they can drive a much better performance and efficiency, power saving compared with a traditional CPU. They can easily improve the performance like 10 to 100x and then only consume like a few percent of the power consumption, so there's a lot of advantage. And also, in the SMB in the other branch office, to the access a cloud, that's where the low end that we see a pretty healthy growth also.

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Operator [24]

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Our next question comes from Mike Casado with Pacific Crest.

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Robbie David Owens, Pacific Crest Securities, Inc., Research Division - Partner and Senior Research Analyst of Security and Infrastructure Software [25]

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Great. Sorry to disappoint, this is actually Rob Owens in for Mike Casado. A couple of things, dovetailing Sterling's question a little bit. So thanks for the color around the competitive landscape. Can you also talk about where you think we are in terms of the firewall cycle? Are there still firewall cycles? Is there any anticipated refresh? We're starting to pick up through some of our channel work that people are looking optimistically at next year. So just some broader color in terms of where you think we are in terms of an overall industry refresh cycle first.

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Ken Xie, Fortinet, Inc. - Founder, Chairman & CEO [26]

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I think that the first cycle probably -- we see the buying pattern in like 2 years ago kind of -- we called it rush buying. Now really the network security equipment probably will survive for 4, 5 years and then they starting to cycle there. I think it's still, like, 1 to 3 years to go. But also the service providers and others like a lot of SMB branch office, we also see pretty strong demand. And also because cyber security is always the most important part of the IT, the total percentage also keep increasing. So we do see the overall market growing pretty healthy. And a lot of existing customers, they also want to expand beyond just the traditional firewall. That's where the fabric, the Security Fabric story started working much better than just refresh the firewall. So you basically can cover from endpoint to the access to the network inside, which a traditional firewall do, and also the application and then the cloud. So that's where -- tying all this together has a much better solution feature compared to refresh. And so we see all this starting to kind of help in the growth.

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Andrew H. Del Matto, Fortinet, Inc. - CFO [27]

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Rob, we were talking about this earlier today, actually. And we always thought that Target, if you go back, I think, it was late '13, that was really the kickoff for the last big, I think, spike, if you will, in spending. And then it went on for a couple of years, obviously. And that -- when you get into '18, that's 4 years ago roughly from that happening and then spending started to happen in '14, early '14. So I think probably somewhere in '18, you would begin to see that click in the [4 to 15]. I think the consolidation theme probably does create an opportunity from a fabric perspective for us, and that's really how we're thinking about this opportunity.

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Robbie David Owens, Pacific Crest Securities, Inc., Research Division - Partner and Senior Research Analyst of Security and Infrastructure Software [28]

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Great, appreciate the color. And then second, if I look at your sequential services revenue, I guess, going back historically, it was flat, up or down a couple of percent. But last year, you saw a spike sequentially from Q4 to Q1 in services. So maybe talk about why this is more normal seasonality, and remind us what happened in that year-ago period, Q1 '16, that drove that services spike. And I apologize if this was referenced earlier, I was late in the call.

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Andrew H. Del Matto, Fortinet, Inc. - CFO [29]

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The services -- I actually think that the answer this year is probably more due to Q3 this year where we had a softer Q3, and so you don't see as much of the registrations come through in Q1 when you would expect the revenue to lift up, start amortizing.

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Ken Xie, Fortinet, Inc. - Founder, Chairman & CEO [30]

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Also, we started to offer what we call enterprise bundle, which has more service component, about 1 year ago. That's also started to help and we see the service percentage to get higher now.

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Operator [31]

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Our next question comes from Walter Pritchard with Citigroup.

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Walter H Pritchard, Citigroup Inc, Research Division - MD and U.S. Software Analyst [32]

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Ken, could you talk about the non-FortiGate business, the size of that and how you're thinking about that kind of medium-term, in terms of how large that may become as a percentage of your revenue?

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Ken Xie, Fortinet, Inc. - Founder, Chairman & CEO [33]

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The non-FortiGate started to grow faster than FortiGate and also fit in the total solution, covering the whole infrastructure instead of just the -- some network side. It looks much better. I don't think we disclosed the detailed percentage yet, but it's starting to get -- definitely growing faster than the FortiGate. Drew, any data we can...

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

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Yes, Walter, I mean, I don't think we're giving numbers out. But I -- generally speaking, that's been the story for the last couple of quarters where we've seen a nice uptick on the fabric and then illustrated in the non-FortiGate products. That's doing well. We also look at the number of fabric customers, if you will. And that's been growing very nicely and a nice trend there, which adds to it. And then, finally, the enterprise bundle, again, was a very strong story in Q1 and very consistent with the last several quarters. So we see a lot of consistency. Kind of the themes internally around productivity seem to be lifting, and part of it doing just to selling multiproduct deals, selling non-FortiGate products, upselling the bundle, the enterprise bundle, and -- so very good on that front.

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Walter H Pritchard, Citigroup Inc, Research Division - MD and U.S. Software Analyst [35]

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And Drew, just a follow-up there. Is it fair to say that if that business were more than 10% of your revenue, you would break it out as non-FortiGate?

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

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We haven't decided on that one, Walter.

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Operator [37]

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Our next question comes from Jayson Noland with Baird.

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Jayson Noland, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [38]

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And Drew, I wanted to follow up on the updated operating model. It seems like sales and marketing would offer the most long-term leverage. And I guess, the question is what's the change now versus the previous guide? Is the expectation fewer headcount adds going forward in sales or a change in how you market the products? Any more color there would be great.

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Andrew H. Del Matto, Fortinet, Inc. - CFO [39]

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Well, a couple of things. I do think you want to start with the top line, Jayson. So we are doing -- the strategy around creating the higher margin, higher price recurring revenue streams, that's obviously coming through. You could see it in the billings, and you could see it in the deferred revenue. We expect that to drive value to the gross margin line over time. And then as you move down into sales and marketing, that's where the bulk of our investments are -- if you go back, historically, that's where we wanted to see the productivity. And the way you get there is some of the things you were talking about, Jayson. But really, what you're trying to do is give them an opportunity to sell more at a higher price. And so I think we're doing well on that front. We just talked about the non-FortiGate sales and the fabric sales. So that's one dimension of that. Then the other thing we did, if you look at the pivot we made in August to really go to what I would call a flatter, very customer-centric sales model, that part is working very well. And from customer-centric, I mean, we're very focused on direct-touch reps versus overlays and very direct [SC] coverage, more direct contact with the customer. We still have -- we're still very focused on the channel, but we have just more direct customer touch. And that was the focus, really scaling out the admin functions over time, and that's where you would have less headcount over time on those functions. We also think the marketing -- the go-to-market end of the marketing is working. Training helps. You get higher productivity through training. We've made investments there. Those are beginning to scale and show fruit in terms of the fabric sales and just the higher productivity overall. So that's really the story there. When you look down the line on R&D and G&A, you probably expect to get a little more out of G&A over time than R&D. Certainly, the revenue project goes away at some point, for instance, and we should see those benefits over time.

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Ken Xie, Fortinet, Inc. - Founder, Chairman & CEO [40]

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Also, there's some change in the whole environment. I think you can see in the last few years, some competitors were aggressively doing the marketing sales. It's more difficult to assess in the long term. And if you -- right now, the whole industry is starting to look more in how to be a little bit more efficient, how is it modeled and sustainable long-term. That's also like -- we also believe this long-term model probably can -- will be better for the shareholder, for the company also.

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Jayson Noland, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [41]

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Okay, makes sense. And then a follow-up if I can, Ken. On the ASIC refresh calendar, any color you can provide on the refresh around the network processor? It seems like it would be important for the high-end of your customer base?

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

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We have a 3 security processor like pretty much every year, there's 1 new come up because, on average, it takes about 3 years to build the particular processor. So the CP9 we just mentioned, like come out and starting to help in the high-end, especially the 7000 Series. Then there's also iSOC and the network processor. I think where we're -- they do not directly impact the revenue because they still need some time to build into the product. And then when we refresh product like a few products every quarter, pretty smoothly, a steady help in the growth. But you can see the latest offer we made on the 7000 Series, that's the latest security processor, CP9, can help the performance growth a lot. And then we probably will see the other next-generation like iSOC, that also can easily improve the performance multiple times. And that also will keep cost the same. That also will help in the growth a lot. But I'll say we'll be -- we're keeping probably on average, 1 new offering or refreshing per year on the security process side.

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Operator [43]

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Our next question comes from Ken Talanian with Evercore.

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Kenneth Richard Talanian, Evercore ISI, Research Division - Analyst [44]

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So first, I was wondering if you could discuss any changes that you've made to either your hiring processes, your systems to better manage your OpEx.

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Andrew H. Del Matto, Fortinet, Inc. - CFO [45]

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Well, Ken, we're very focused on making sure that we look at every -- open headcount req and every -- the background of everyone coming in the door. And that's part of the flat structure that we're talking about where Ken, myself and Lisa, our VP of HR, are all focused on looking at every req and every person who comes in the door and their background to make sure it fits. We also evaluate where we are. And I think the key here is you want to bring people in, you want to make sure that they're going into a place where we feel there's fertility and opportunity for them to be productive, both near- and long-term. And so that's what we're really trying to do, and then balance the precious investments we have over time into those roles. And the last thing I would add is when you think about the ramp of this, you want to do it in a way that doesn't create disruption because, clearly, if you go too fast, it just becomes disruptive. That's how we think about it. But we really want to keep a flat organization, very much -- and we've been saying this for several quarters now -- laser-focused on productivity. And that is the primary driver.

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Ken Xie, Fortinet, Inc. - Founder, Chairman & CEO [46]

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Yes. And also the mid-20 operating margin, we have achieved that like in 2012. So we have reached the level before. And then just in the last few years, we kind of more invested in the growth. Now kind of more go back to the normal and take care of both the profit and the growth side.

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Kenneth Richard Talanian, Evercore ISI, Research Division - Analyst [47]

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Okay. And just curious, if the economy were to turn negative over the next few years or the security market were to turn, would you be willing to forgo top line growth to hit those margin targets?

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Ken Xie, Fortinet, Inc. - Founder, Chairman & CEO [48]

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I've been in the industry for like the 20-plus years. Sometimes even the -- when the economy go slow, they do not impact security that much because they still want to keep the security. And also security is pretty sticky, and it is difficult to replace. The cost could be higher.

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Andrew H. Del Matto, Fortinet, Inc. - CFO [49]

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Ken, I think the -- look, the answer is you obviously want to step back and look at what's going on in the industry, but we're very focused and committed to driving the higher margins. I mean, that's the model we're operating under. And again, we're trying to ramp there in a productive way, if you will. We feel like we've done a very good job of building the model we wanted to do over the last couple of years in terms of our go-to-market adjustments that we've made. We find those and then we're very focused on the higher-margin recurring revenue streams which are also coming in. So that's where we're going.

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Kelly Blough, [50]

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And I want to say we've got about 10 more people lined up for questions. So I might have to try to restrict people to single questions going forward and then we can follow up again on the second call, please.

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Operator [51]

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Our next question comes from Michael Turits with Raymond James.

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Michael Turits, Raymond James & Associates, Inc., Research Division - MD of Equity Research and Infrastructure Software Analyst [52]

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So very good to see the milestones on the margins and the guide to 150 bps to 200 bps after '17. But let me take it from -- this margin question with a slightly different perspective, which is why, in theory, couldn't we get to 20%-plus margins even sooner when you were at mid-20s margins, when you were a much smaller company growing with less scale and growing over 20%? So what's different about now? What's changed such that you actually have to invest at a higher rate that you couldn't get there even sooner than this?

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

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Well, Michael, I think you want to balance productivity against disruption, the impacts and the risks of disruption. We've done a very good job of rebuilding the model, we believe. We pivoted to the enterprise, and that's doing very well. And we want to continue to drive those higher margins, and we're going to look at everything we can to achieve our results or better. But you know I think you have to be very careful to avoid disruption. And I think some people have seen that recently, some others have seen that. And so I think that's part of the issue because those can be very damaging both short- and long-term.

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Operator [54]

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Our next question comes from Andrew Nowinski with Piper Jaffray.

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Andrew James Nowinski, Piper Jaffray Companies, Research Division - Principal and Senior Research Analyst [55]

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So your product revenues remain well above your peers. Even today, Check Point called out strength in the small and midmarket, yet they only had about 2.9% growth in product revenue this quarter. And obviously, Palo Alto is seeing some product revenue declines. So can you just give us any color as to what drove the strength in your product revenue this quarter and kind of what you're expecting that to stay at through FY '17 for -- based on your new guidance?

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

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Yes. I think some of the new product like whether the E model and also some high-end product offered to the big enterprise service provider has helped drive the growth. And also we have quite a big installation base. I think based on IDC, probably like more than 25% of the global installed base is a Fortinet, FortiGate solution there. So that's also helped in keeping driving -- and we also keep refresh the product, which like I said earlier, like every few years, a customer also need to refresh the product to get a better performance, more function. That's also helping drive the product growth. And the service also because the new product can offer additional function, additional service. That's also kind of helping to drive the long-term service growth.

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Andrew James Nowinski, Piper Jaffray Companies, Research Division - Principal and Senior Research Analyst [57]

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Got it. And then what level are you expecting for the remainder of '17, can you keep it in this high single digits?

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Andrew H. Del Matto, Fortinet, Inc. - CFO [58]

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Yes. We don't -- unfortunately, we don't guide on product revenue, Andrew. The one thing I would mention is we try to -- I think we try to be helpful with the mix shift in Q3, it was about -- we thought about 200 to 300 basis points of product revenue that's now reflected on the services line. If you think of it as being more software that's ratable, more metered model, those appear on the services line. And then also with the enterprise bundle, you end up reattributing through accounting more of the product from the invoice on to the services deferred revenue, and then amortizes over time. So if you measure that, that's probably close to 500 bps that's really now that -- a year ago, probably it would have shown up on the product line, but it's now showing up on the services line. It's a big number, yes.

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Operator [59]

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Our next question comes from Saket Kalia with Barclays.

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Saket Kalia, Barclays PLC, Research Division - Senior Analyst [60]

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Drew, I've got a philosophical question for you, maybe a slightly different way of asking Mike Turits' question earlier. But what factors went into updating the long-term model? We certainly appreciate the path and the milestone, but we're just -- I was just wondering, is this something that -- is it part of sort of a normal 5-year planning type of process? Or what went into kind of thinking about profitability even beyond the original fiscal '20 target?

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Andrew H. Del Matto, Fortinet, Inc. - CFO [61]

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Well, philosophically, we were just, I think, at the next stage of the company. If you go back a few years, we took down the margins really because we wanted to build out an enterprise sales force and a broader go-to-market model, so to speak, broader go-to-market model. That took some investment, and we refined it along the way. And we feel now, as we've gone through a couple of quarters here, a year passed, I think, reorganizing, if you will, the sales force in the U.S. And we feel like we're doing very well. There's also -- and we felt like the maturation of the model would then provide the benefits that we were hoping for all along. And we look at that -- obviously, we model it. We look at the vectors of that. Clearly, the mix shift on the gross margin line, helpful. The -- looking at productivity, and you look at the natural ramp forward over time. And also, I mean, we received a lot of shareholder feedback, to be frank. And we want to make sure that, one, we show we appreciate our shareholders' feedback, and we continue on -- continually focus on creating, increasing shareholder value. So we appreciate everybody's feedback. They're very helpful.

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Operator [62]

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Our next question comes from Shaul Eyal with Oppenheimer.

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Shaul Eyal, Oppenheimer & Co. Inc., Research Division - MD and Senior Analyst [63]

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Drew, solid performance in the Americas. I know you guys don't break out the U.S. contribution within the slides. But can you provide us with some qualitative description of Fortinet's progress in the U.S. during the quarter? Whatever color you can share with us.

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Andrew H. Del Matto, Fortinet, Inc. - CFO [64]

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Yes. The billings right from the U.S. was very good, it was about 31%. And so again, that's where we made a lot of the investments. And whether you -- when you look at that kind of near-term and longer-term, that's -- you get very comfortable that -- we started to get very comfortable with the productivity and improvements in the things we talked about, rebuilding the go-to-market model and the refinements we've made over time. It feels like -- the numbers indicate that, that is going in the right direction.

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Operator [65]

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Our next question comes from Catharine Trebnick with Dougherty.

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Catharine Anne Trebnick, Dougherty & Company LLC, Research Division - VP and Senior Research Analyst [66]

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Mine is more on the service provider avenue. It seems like a lot of the next-generation implementations in their core network will be NSE, SDN-like. And what could be architectures that Fortinet has that would be most apt to go after that type of opportunity?

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Ken Xie, Fortinet, Inc. - Founder, Chairman & CEO [67]

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That's where both the new 7000 Series, also the newly released, FortiOS 5.6, offer a lot of this function. And where that demand, the SDNs, some other were now a function of virtualization. That's where the -- we got a lot of the feedback from our service provider, from the core provider, the customer, which we integrate into both the new hardware and also the new software.

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

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Catharine, we constantly engage with our cloud and carrier team and ask them what to expect. And they continually tell us that we're in all of the top carriers. We're working with them on their architectures. And the breadth of portfolio, the fabric matters and, obviously, historically, performance matters. But we can help them, whether it's virtual or physical. And the other factor that we tend to see is just that they want to run their businesses inside out, so what they're sharing, what they're using or providing to their customers, they also want to run their systems on and run their business. And we feel like we're in those top prospects that are forthcoming.

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Operator [69]

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Our next question comes from Erik Suppiger with JMP Securities.

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John Alexander Lucia, JMP Securities LLC, Research Division - VP and Research Analyst [70]

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This is John on for Erik. I just look at your headcount additions. It looked like you added 50 headcount per quarter over the last 3 quarters. It looks like the lowest levels since 2011. So firstly, is this intentional? Or would you like to be adding more headcount than that? And then, secondly, is increased attrition weighing on your headcount growth? Or has attrition remained constant over the last year?

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Andrew H. Del Matto, Fortinet, Inc. - CFO [71]

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Erik (sic) [John], we evaluate the headcount based on the value they bring back to us. So again, we're doing a couple of things. We're trying to make sure we're covering the right opportunities both from a customer perspective and then also from an R&D perspective and then the various other things we need to do to grow and scale the operations. But we're very focused on looking at the headcount requisitions that we open, and they tie to that model that they bring back an appropriate incremental returns so that, one, that it makes sense near-term but also long-term. Then Ken, myself and, as I said, Lisa, VP of HR, look at every hire that comes in the door from a resume perspective and what they're doing. And I think we just become increasingly focused on -- we said several quarters ago, we're laser-focused on productivity, and we continue to do that. And we feel like that mode of operation, that process is working very well.

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John Alexander Lucia, JMP Securities LLC, Research Division - VP and Research Analyst [72]

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So should we expect 50 going forward, 50 headcount additions going forward this quarter?

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Andrew H. Del Matto, Fortinet, Inc. - CFO [73]

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Well, we've really been guiding on operating margin, Erik.

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Operator [74]

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Our next question comes from Patrick Colville from Arete Research.

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Patrick Colville, Arete Research Services LLP - Analyst [75]

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So the guidance implies for billings revenue a pretty steep sequential deceleration. Can you just help me understand what I might be missing? So that kind of manifests itself because momentum's really strong.

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Andrew H. Del Matto, Fortinet, Inc. - CFO [76]

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Well, look, a couple of things, Patrick. One, the -- clearly, if you think about our business and how it's changed over time, first of all, our SMB channel business is fine, very consistent. It has been doing very well. We've gone more into the enterprise. And what happens then is you now have inherently a more -- I hate to say -- use this word, lumpiness, to the business. And it just tends to be more pushed towards the end of the quarter. And so we're trying to do our best to adjust for any of that in terms of timing and take that all into account. Any given quarter, you can get 1 or 2 large deals that could dramatically influence the results and -- for instance, this first quarter, we had the university -- the deal that we spoke about earlier, the $12 million -- the deal that was slightly north of $12 million. So that can happen. We're just trying to take all those things into account when we look at it.

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Operator [77]

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Our next question comes 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 [78]

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Drew, just wanted to double-click on the comments you made around productivity. It's very evident in the results that the changes you've made and the investments you've made have been paying off. But I'm curious if you can maybe qualitatively talk about sales force tenure and attrition levels, especially as we've now anniversaried Patrice's changes in North America. So any qualitative color around that would be very helpful.

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Andrew H. Del Matto, Fortinet, Inc. - CFO [79]

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Yes. I think, we've done a -- Fatima, it feels like we've done a great job of hiring the right people to approach the enterprise. And so that's worked well. We don't -- typically, we aren't going to share exact tenure statistics. But I would say that statistic has improved since Q3, I think, when we did share some. So we feel like we're better positioned, and we're seeing that more consistent performance over time. And I really think that's the key driver, just getting people in the seat, getting them trained and the consistent performance.

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Ken Xie, Fortinet, Inc. - Founder, Chairman & CEO [80]

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Also, the marketing side also has started to help and contribute in the results. And then, also, we offer probably the best and biggest training program in the industry. That's for both on the customer and partner, and also even our own sales force side also started to benefit from all the training program we did.

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Operator [81]

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And we have time for one more question. It comes from the line of Tal Liani from Bank of America.

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Michael Feldman, BofA Merrill Lynch, Research Division - Research Analyst [82]

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This is Mike on behalf of Tal. So billings growth rate was solid this quarter, up 22%, but your guidance is calling for a deceleration to about 15% in the second quarter. Can you give us a little color on -- are any of the areas in your pipe -- what are the areas in your pipeline that are contributing to some of that deceleration?

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Andrew H. Del Matto, Fortinet, Inc. - CFO [83]

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Mike, Fatima asked a similar question just a minute ago, so let me repeat what I said and then maybe add a little bit on to that. There's various elements or parts of our business, if you will, dimensions. And so think of this SMB as being a fairly consistent flow of business. And so that one tends to be a little easier to predict, if you will. The -- we've been more focused on the enterprise. We've been very successful there. We're seeing the uptick in larger deals. The -- what goes along with that, though, tends to be more of the deals falling into quarter-end, closer to quarter-end, as enterprises are very good at pushing you to that to get the best deal. And so that timing -- the lumpiness and timing that goes along with that are really addressed in how we guide. We're thinking about that very closely as we guide. What I would say, there was a larger deal that we mentioned during the quarter, and I think if you adjust for that a little bit and you come off of -- you'll come in to a more, what I would probably consider, a historical sequential range for us from Q1 into Q2. And hopefully that's helpful, Mike.

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Operator [84]

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I would now like to turn the call back over to Ms. Kelly Blough for closing remarks.

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Kelly Blough, [85]

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Thank you, everyone. I’m sorry we couldn't get to a couple of questions. Please do call in again at 2:30 -- 3:30, excuse me, for our next phone call. Thank you. And we'll talk to you then.

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Operator [86]

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Ladies and gentlemen, thank you for your participation in today's conference. This does conclude the program. You may now disconnect. Everyone, have a great day.