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Edited Transcript of FTNT earnings conference call or presentation 6-Feb-20 9:30pm GMT

Q4 2019 Fortinet Inc Earnings Call

Sunnyvale Feb 7, 2020 (Thomson StreetEvents) -- Edited Transcript of Fortinet Inc earnings conference call or presentation Thursday, February 6, 2020 at 9:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Keith F. Jensen

Fortinet, Inc. - CFO & CAO

* Ken Xie

Fortinet, Inc. - Founder, Chairman & CEO

* Peter M. Salkowski

Fortinet, Inc. - VP of IR

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Conference Call Participants

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* Andrew James Nowinski

D.A. Davidson & Co., Research Division - MD & Senior Research Analyst

* Brad Alan Zelnick

Crédit Suisse AG, Research Division - MD

* Brian Lee Essex

Goldman Sachs Group Inc., Research Division - Equity Analyst

* Chaim Siegel

Elazar Advisors, LLC, Research Division - Analyst

* Daniel Harlan Ives

Wedbush Securities Inc., Research Division - MD of Equity Research

* Fatima Aslam Boolani

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

* Imtiaz Ahmed Koujalgi

Guggenheim Securities, LLC, Research Division - Director of Technology, Media & Telecom and Analyst

* Jonathan Frank Ho

William Blair & Company L.L.C., Research Division - Technology Analyst

* Melissa A. Franchi

Morgan Stanley, Research Division - VP and Research Analyst

* Michael Turits

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

* Nicholas Andrew Yako

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

* Patrick Edwin Ronald Colville

Arete Research Services LLP - Analyst

* Robbie David Owens

Piper Sandler & Co., Research Division - MD and Senior Research Analyst

* Shaul Eyal

Oppenheimer & Co. Inc., Research Division - MD & 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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Ladies and gentlemen, thank you for standing by, and welcome to the Fortinet Fourth Quarter 2019 Earnings Announcement. (Operator Instructions) Please be advised that today's conference is being recorded. (Operator Instructions)

I would now like to hand the conference over to your speaker today, Peter Salkowski. Please go ahead.

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Peter M. Salkowski, Fortinet, Inc. - VP of IR [2]

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Thank you, Tara. Good afternoon, everyone. This is Peter Salkowski, Vice President of Investor Relations at Fortinet. I'm pleased to welcome everyone to our call to discuss Fortinet's financial results for the fourth quarter and full year of 2019. Speakers on today's call are Ken Xie, Fortinet's Founder, Chairman and CEO; and Keith Jensen, our Chief Financial Officer.

This is a live call that will be available for replay via webcast on our Investor Relations website. Ken will begin our call today by providing a high-level perspective on our business. Keith will then review our financial and operating results, providing our guidance for the first quarter and full year of 2020, before opening the call for questions. (Operator Instructions)

Before we begin, I would like to remind everyone that on today's call, we will be making forward-looking statements, and these forward-looking statements are subject to risks and uncertainties, which could cause actual results to differ materially from those projected. Please refer to our SEC filings, in particular the risk factors in our most recent Form 10-K and Form 10-Q for more information.

All forward-looking statements reflect our opinions only as of the date of this presentation, and we undertake no obligation and specifically disclaim any obligation to update forward-looking statements.

Also, all references to financial metrics that we make on today's call are non-GAAP, unless stated otherwise. Our GAAP results and GAAP to non-GAAP reconciliation is located in our earnings press release and in the presentation that accompanies today's remarks, both of which are posted on our Investor Relations website. Lastly, all references to growth are on a year-over-year basis, unless noted otherwise.

I will now turn the call over to Ken.

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

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Thanks, Peter, and thank you to everyone for joining today's call to review our fourth quarter and full year 2019 results. We are pleased with our very strong fourth quarter performance. Billings increased 24% to $802 million driven by solid execution and growth across each of the Americas, EMEA and APAC. Revenue increased 21% to $614 million, with product revenue up 19% and service revenue up 23%. Non-GAAP operating margin was 27%. For 2019, billings increased 21% to $2.6 billion. Revenue was up 20% to $2.2 billion. And our non-GAAP operating margin was 25%.

These strong results were driven by our advanced FortiGate technology with SPU and Secure SD-WAN, our integrated Security Fabric platform and hybrid multi-cloud offerings.

Fortinet was recently named one of the top 3 vendors in the 2019 Gartner Magic Quadrant for WAN Edge infrastructure. Fortinet's security-driven networking approach to SD-WAN offers customers the most comprehensive solution with security and enterprise-grade networking capability integrated in a single box. Our unique approach has allowed us to gain significant market share over the past 12 months. With more than 21,000 companies using Fortinet's Secure SD-WAN solution and 70% of top-tier service providers offering our SD-WAN solutions, we are now the leading SD-WAN vendor.

Today, we announced the release of FortiGate 40F, the most affordable next-generation firewall with Secure SD-WAN. The 40F includes our new SoC4 security processor. The 40F delivers Security Compute Ratings of 3 to 23 times faster than industry average appliance, which use generic CPUs.

The traditional perimeter-based network security has expanded across the entire infrastructure. To the wide area network, including SD-WAN and 5G, and to the local area network, including WiFi and internal segmentation, Fortinet's ability to offer security-driven networking and high performance with our SPU technology are clearly competitive advantages.

Going forward, we are working hard to ensure that Fortinet's 3 growth engines will help us grow faster than our competition and the market overall. First, we continue to gain market share in network security driven by our SPU competitive advantage. Our SPU technology enables us to add cutting-edge security and network functionality, including SD-WAN, while maintaining strong performance despite network traffic continuing to increase. The introduction of the new FortiSPU, like SoC4 and NP7, as well as the first FortiGate product build with NP7 to be announced later this month, is expected to widen our competitive advantage.

The second growth engine is our Security Fabric platform, including hybrid and multi-cloud deployments. Unlike a competitive platform that brings together loosely integrated acquired solutions, Fortinet's Security Fabric, which from the very beginning was the most developed internally, offers a broad, automated and truly integrated security platform for end-to-end protection, making it easier for a customer to consolidate to a few security vendors.

Third, our engineering-focused culture of continuous innovation strongly positions Fortinet for long-term growth and competitive advantage. With at least 3x the technology patents compared to our competition, Fortinet's IoT, OT, 5G, hybrid cloud and edge solutions are leading the transition to the latest generation of cybersecurity.

I want to thank the Fortinet team and our partners for their ongoing hard work and our customers for their support. Now I will turn the call over to Keith for a closer look at our fourth quarter and full year performance and to provide guidance for 2020.

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Keith F. Jensen, Fortinet, Inc. - CFO & CAO [4]

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Thank you, Ken. Let me first note that except for revenue, financial amounts are non-GAAP and growth rates are based on comparisons to the fourth quarter and full year of 2018, unless stated otherwise. The slide references I make refer to the presentation posted on our Investor Relations website.

I would now like to provide a summary of our strong fourth quarter performance and follow up on certain metrics from the Analyst Day. We believe the metrics we shared last November highlight our diversity by geography, customer size, industry segments and solutions as well as provide insights into our financial model.

Let's start our fourth quarter review with revenue. Total revenue of $614 million was up 21%. Revenue growth was led by the fabric and cloud segments, with over 30% growth, followed by network security growth at 18%. Product revenue growth was 19% or $239 million, benefiting from both legacy firewall use cases and consistent with Ken's SD-WAN commentary, from continued adoption of our FortiGate-based Secure SD-WAN solution. Simply put, our Secure SD-WAN firewall use case combines, in a single appliance, security with application-aware routing that can lower MPLS and other costs.

The fourth quarter revenue growth of 19% was consistent with our strong third quarter performance, even when faced with a more difficult year-over-year comparison. We believe our product revenue growth may be among the highest in this network security industry.

Moving to service revenue. Our higher-margin service revenue increased 23% to $376 million and represented 61% of total revenue, increasing 10 points in 4 years. FortiGuard security subscription revenue increased 24% to $205 million. FortiCare technical support and other service revenue increased 21% to $170 million. Renewal rates remained consistent with prior periods and within the guidelines we provided at the Analyst Day. Deferred revenue at the beginning of the fourth quarter accounted for approximately 90% of service revenue. Revenue growth on a geographic basis saw the Americas up 23%, APAC up 22% and EMEA up 19%.

Before continuing with our fourth quarter results, I would like to highlight our revenue performance for the year. Total revenue for the full year grew 20% to $2.2 billion. Product revenue grew 17%. Service revenue grew 21% and represented 63% of total revenue.

Now turning to the fourth quarter with a focus on billings. Total billings increased 24% to $802 million. Network security product and service billings increased 20% and accounted for 73% of total billings. Illustrating the continued traction with our fabric platform and cloud strategies, non-network security billings increased 35%.

In Europe, we saw Germany perform better than planned, while in the U.K., billings declined. The U.K. decline appears related to Brexit distractions, and we expect U.K. billings growth will return to positive territory in the current quarter.

Looking at verticals -- billings by verticals, service providers and MSSPs accounted for 18% of total billings. And we experienced outpaced growth from government, financial services, retail and education. As a follow-up to the Analyst Day, I would note the top 5 verticals, again, accounted for 65% of total billings. At year-end, total deferred revenue increased 27% to $2.1 billion and short-term deferred revenue increased 22% to $1.2 billion.

Looking now at deal sizes and illustrating our continued expansion into the enterprise market, deals over $1 million increased 36% to 64 deals. Secure SD-WAN was a leading contributor to the increase in the number of deals in excess of $1 million, accounting for 10 deals in the quarter, up from 4 deals last year. And with a reference to our diversification, we have now completed 11 quarters in a row without a single transaction representing over 2% of quarterly billings. The number of deals over $250,000 increased 29% to 469. And the number of deals over $500,000 increased 53% to 197.

In the fourth quarter, our average contract term increased 1 month to 26 months. As we noted at the Analyst Day, Secure SD-WAN transactions included a greater mix of enterprise customers and somewhat longer contract terms.

Moving back to the income statement. In the fourth quarter, gross margin improved 230 basis points to 78%. Product gross margin improved 400 basis points to 61.9%. As we saw in the third quarter, product gross margin benefited from gains in average selling price as well as lower direct unit cost and indirect cost. We are pleased with the product gross margin improvement we have achieved in each of the last 2 quarters.

Services gross margin increased 90 basis points to 88.2%. Operating margin for the fourth quarter increased 110 basis points to 26.8%. The improvement in gross margin was partially offset by an increase in the pace of hiring, mostly in sales and marketing, lower sales attrition and spending associated with the recent M&A activity. For the full year, gross margin was 77.5%, up 150 basis points from 2018, benefiting from a 190 basis point improvement in product gross margin. And for the full year, the operating margin was 24.5%, up 220 basis points from 2018.

Total headcount ended the year at 7,082, an increase of 21% from the end of 2018. However, the 2 fourth quarter acquisitions increased headcount by 135. Excluding these 2 acquisitions, headcount would have increased 19%. Given the strong operating income performance, net income for the fourth quarter was $132 million or $0.76 per diluted share. Net income for the full year was $432 million, an increase of 35%, resulting in earnings per diluted share of $2.47.

On a GAAP basis, we reported full year net income of $327 million or $1.87 per diluted share. This represents our 11th consecutive year of GAAP profitability, a milestone we had been able to achieve every year since becoming a publicly traded company in 2009.

Moving to the statement of cash flows summarized on slides 10, 11 and 12. Adjusted free cash flow for 2019 increased 28% to $776 million. Capital expenditures for the fourth quarter were $47 million, including $36 million on real estate spending. For 2020, capital expenditures are expected to be between $210 million to $240 million, which includes spending on the campus expansion. We expect first quarter total capital expenditures to between $25 million and $35 million, again including spending on the campus expansion.

In the fourth quarter, we repurchased approximately 303,000 shares of our common stock for a total cost of $23 million. For the full year, we repurchased 1.9 million shares for a total cost of $141 million. At the end of the fourth quarter, the remaining share repurchase authorization was $1.6 billion, with the plan set to expire at the end of February 2021.

Before wrapping up with guidance, I would like to offer information on 2 additional areas: our fourth quarter acquisitions; and also SD-WAN. First, on the M&A side, we completed 2 technology and talent tuck-in acquisitions in late October and December. With the combined contribution to fourth quarter revenue significantly less than 1%, these acquisitions pulled down fourth quarter operating margin by approximately 1/2 of a percentage point. We expect the impact from these acquisitions on the first quarter and full year 2020 operating margins to be roughly a 100 basis point headwind.

Second, our Secure SD-WAN offering continues to be a point of differentiation for Fortinet. In the fourth quarter, Secure SD-WAN billings represented high single digits of total billings. In 2019, for the full year, Secure SD-WAN added about 7 points to product revenue growth and represented mid- to high single digits of total billings. On a full year basis, there were no significant changes to the year-to-date third quarter metrics for Secure SD-WAN that we provided at the Analyst Day.

Service contracts continue to attach to the FortiGates at a rate consistent with other FortiGate use cases. And finally, new logos continue to account for approximately 50% of Secure SD-WAN billings.

Next, I would like to review our outlook for the first quarter and full year 2020, summarized on Slide 13, which is subject to the disclaimers regarding forward-looking information that Peter provided at the beginning of the call. For the first quarter, we expect billings in the range of $635 million to $655 million; revenue in the range of $555 million to $565 million; non-GAAP gross margin of 77.5% to 78.5%; non-GAAP operating margin of 19% to 20%; non-GAAP earnings per share of $0.50 to $0.52, which assumes a share count of between $175 million and $177 million. We expect a non-GAAP tax rate of 24%.

As I begin to provide 2020 guidance, I would like to remind everyone of the financial model expectations for the next 3 years that was provided at the November Analyst Day. For the period from 2020 through the end of 2022, we expect organic billings and revenue growth to be at least 15% for each of the next 3 years and non-GAAP operating margin to average at least 25% during this 3-year period. For 2020, we expect billings in the range of $3,025,000,000 to $3,075,000,000; revenue in the range of $2,525,000,000 to $2,555,000,000; total service revenue in the range of $1,635,000,000 to $1,655,000,000; non-GAAP gross margin of 77.5% to 78.5%; non-GAAP operating margin of 23.5% to 24.5%. While we estimate the recent acquisitions will be a 100 basis point year-to-year headwind to our 2020 operating margin, included in the numbers above, we believe our operating margin over the next 3 years will average at least 25%.

Non-GAAP earnings per share of $2.70 to $2.73, which assumes a share count of between 180 million and 182 million. We expect our non-GAAP tax rate to be 24%. We expect cash taxes to be approximately $40 million.

Along with Ken, I would like to welcome the CyberSponse and again, the enSilo teams to Fortinet, and thank our partners, our customers and the Fortinet team for all their support and hard work. With that, I will hand the call back over to Peter.

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Peter M. Salkowski, Fortinet, Inc. - VP of IR [5]

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Thank you very much, Keith. Operator, we're ready to open up for Q&A, please.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from the line of Brian Essex with Goldman Sachs.

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Brian Lee Essex, Goldman Sachs Group Inc., Research Division - Equity Analyst [2]

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And congratulations on some nice results. I was wondering, Keith, if maybe you could unpack the guidance a little bit. Coming in, particularly on the growth side of the equation, several hundred basis points over your kind of at least 50% -- 15% guide on the Analyst Day, where does the confidence there come from? And what are some of the levers that could, I guess, give us some comfort that there's the appropriate level of conservatism in that number?

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Keith F. Jensen, Fortinet, Inc. - CFO & CAO [3]

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Yes, I think the -- when you look at a longer-term model, you're probably looking more at Gartner growth rates in terms of what you expect to see from SD-WAN, what you expect to see in the network firewall and what you see -- what you expect to see in the fabric. And I think the guidance is certainly within those ranges when you factor in our historical ability to outgrow the market. I think as you get -- if you pull that in, particularly to, say, the first quarter or even the current year, it's much more based upon the pipeline. And when we look at the pipeline and the opportunities that we see in the pipeline, it clearly supports the guidance that we've just provided.

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

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Also, we do increase the sales capacity with the additional hiring in the sales and marketing. Reaching close to 20% total headcount increase will definitely help to drive additional growth.

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Brian Lee Essex, Goldman Sachs Group Inc., Research Division - Equity Analyst [5]

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Got it. That's helpful. And maybe if I could follow up with a quick one on the current results for the quarter. Product revenue, nicely strong in the high teens and services revenue as well during a quarter where maybe some of your peers found it a little more challenging to put up positive product revenue growth at the very least. How much did, I guess, SD-WAN and fabric contribute to each of those segments? And how might you view the overall spending environment for core firewall considering the results that you had? And I did hear you comment on high single-digit SD-WAN contribution, but if maybe you could paint a bigger picture of other contributing factors to those line items and the spending environment overall would be really helpful.

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Ken Xie, Fortinet, Inc. - Founder, Chairman & CEO [6]

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Yes, this is Ken. For the network security, we believe we are simply gaining a lot of market share because the product architecture with our own ASIC, what we call SPU, is -- has huge computing power and can keep adding whether a security function or the networking function of SD-WAN. Like even the product we announced today, like that's from 3x to 23x more powerful than other competitor industry average. So this will make us keeping gaining market share. And also, the SD-WAN market, last year, is about $1.5 billion and they grow 15% year-over-year in the next few years. So we are now the leading vendor in SD-WAN, with the most customers and also the most service providers also starting to adopt our SD-WAN solution. So we do believe we're also keeping gaining share in that space. So that also will help us. And the fabric, you can see almost double the network security growth because our fabric is mostly internally developed and well integrated. That's more easy to like upsell, cross-sell once some product gets in and because of the other part of fabric kind of working together quite well. So that's where customers see the benefit of consolidation, so we see that's also a growth driver.

There's a few other new technology we also pioneered, and -- but that's probably more long term, maybe still a few more years to see materialize, but we do -- we also lead in some of the technology changes in the space.

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Operator [7]

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Our next question comes from the line of Brad Zelnick with Crédit Suisse.

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Brad Alan Zelnick, Crédit Suisse AG, Research Division - MD [8]

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And I'll echo my congratulations, what a real strong finish to 2019 and an impressive guidance as well. Ken, if I can ask you a question. As I look to competing SD-WAN solutions out in the market, I think there are some out there that take a different architectural approach in delivering it mainly as a cloud service. Aside from customer preference, can you maybe speak to the architectural trade-off of centering the functionality in the cloud versus delivering it as you do?

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Ken Xie, Fortinet, Inc. - Founder, Chairman & CEO [9]

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I think by moving some applications to the cloud actually helping like a multi-deployment in SD-WAN and at the same time, even within the cloud, there's a few research, actually whether from the government and I'll say, or come from like academia like a CMU, that the cloud actually increased the security risk, and that's where even within the cloud, you also need to secure the cloud itself. So that's also helping like, we call it, hyperscale, some other kind of approach to get inside the network. And so that's probably beyond the traditional -- I mean the WAN, SD-WAN side.

So that's where we kind of have been working with a lot of service providers, cloud providers, and making SD-WAN a part of their total offering. And then we also understand, sometimes, they have their own business model, with most supporting each other, instead of competing with each other. So that's kind of the ecosystem that started working quite well for us.

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Brad Alan Zelnick, Crédit Suisse AG, Research Division - MD [10]

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That's very helpful, Ken. And Keith, if I could just follow up with a quick one for you. DSOs seem to be running a little bit hot. Can you comment at all on linearity? I mean at the same time, you have obviously guided to a very nice Q1 and full year next year. But any color on the jump would be helpful.

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Keith F. Jensen, Fortinet, Inc. - CFO & CAO [11]

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Yes, I think the math of DSO, we picked up about a day from the acquisitions. That pretty much puts us back in line with what you would expect normally. I would offer my experience in high-tech when Christmas holiday season is always very busy. I still think Fortinet's unusual.

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Operator [12]

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Our next question comes from the line of Melissa Franchi with Morgan Stanley.

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Melissa A. Franchi, Morgan Stanley, Research Division - VP and Research Analyst [13]

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Congrats on a solid quarter. Ken, it looks like you're seeing good growth in large deals and multimillion-dollar deals. And I know that you said that SD-WAN is a leading contributor to the strength there. But I'm just wondering if you could provide more color on what those deals look like. Is it your existing customers that are refreshing at the branch? Or are you displacing some competitor solutions that are coming -- and you're coming in because of the SD-WAN capability?

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

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So half the SD-WAN customers, the new customers, especially come from what's enterprise. That also enable us to get into the traditional enterprise network security space or even the internal, like you've been saying. The traditional parameter-based network security now need to be expanded to the WAN side, like SD-WAN and 5G, and also to the internal, like whether the internal segmentation, switching to the internal WiFi. So that's where we see that, probably, the internal is even a bigger market compared to the SD-WAN, the WAN side.

And so we see a huge opportunity, especially, we introduced the new NP7. So the first product leverage, NP7, which is about 5x faster than the previous chip, NP6, will help us get inside a network in a very high-speed environment within the cloud. So that's also what drives additional growth. So I do see, so the SD-WAN go to the WAN side and also go to the internal network side, help us expand a lot of our new markets inside the enterprise and also gain a lot of new customers for us.

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Melissa A. Franchi, Morgan Stanley, Research Division - VP and Research Analyst [15]

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Okay. Very helpful. And then I have a follow-up for Keith. Keith, you mentioned that ASPs were increasing in your commentary on gross margins. Can you just maybe comment on what's driving that ASP increase? Is that just a mix shift dynamic? Or did you actually raise prices on appliances?

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Keith F. Jensen, Fortinet, Inc. - CFO & CAO [16]

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Yes, I think the -- I think what I'm trying to do is parse out the fact that in the benefit to gross margin, there was really 3 pieces to it. Indirect, which I would attribute to the economies of scale that we're seeing. We have a large warehouse facility that we acquired a number of years ago that -- and I think that's a fairly "permanent benefit" on the indirect side. On the direct side, I think the operations team does a very good job of each quarter working down the average direct unit cost. And then the third component was ASP. And I kind of broaden that conversation, if you will, a talking point. From the last quarter, I attributed it to discounting. And the reason for that is I would put discounting as a component of ASP, but I also want to give some credit to the ability to -- of the company, if you will, to maintain the somewhat normal price list changes that you have from time to time and not giving up those back -- giving those back in discounting.

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Ken Xie, Fortinet, Inc. - Founder, Chairman & CEO [17]

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The other economy of scale working is really the ASIC chip, right? So we are the #1 unit shipment, probably more than the #2, #3, #4 combined as well help us, where it kind of lower the average cost of per ASIC chip, which give us huge computing power over the generic CPU the competitors are using. So that's also helping driving the cost lower.

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Operator [18]

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Our next question comes from the line of Shaul Eyal with Oppenheimer.

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Shaul Eyal, Oppenheimer & Co. Inc., Research Division - MD & Senior Analyst [19]

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Congrats on a strong performance. Keith or Ken, Germany and the U.K., or maybe we should call it Frankfurt and then London, tale of 2 countries, tale of 2 cities. Talk to us a little bit about what has been driving the strength in Germany and why do you expect the U.K. to bounce back in the first quarter?

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Keith F. Jensen, Fortinet, Inc. - CFO & CAO [20]

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Yes. I think the -- sorry, Ken, I didn't mean to jump on you. I think -- in Germany, I think it's just been -- it's been a balanced growth throughout the quarter. I think we came into the quarter with perhaps some concerns given the economy there in Germany, but the diversification that we see within the country, I think, paid off for us. I think in the U.K., to answer the question very specifically, when I look at the pipeline in Q1 versus what we saw in Q4, I feel very comfortable to comment about it, returning to positive growth in the quarter.

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Shaul Eyal, Oppenheimer & Co. Inc., Research Division - MD & Senior Analyst [21]

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Fair enough. Fair enough. And maybe along the same lines, nice bounce in APAC. What's driving that? And do you see that contribution or growth as sustainable within that region?

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

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Yes. APAC has a pretty good fourth quarter. And also, we started to speed up some hiring there, which is a little bit behind early last year, which is also going to help drive the future growth.

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Operator [23]

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Our next question comes from the line of Fatima Boolani with UBS.

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Fatima Aslam Boolani, UBS Investment Bank, Research Division - Associate Director and Equity Research Associate Technology-Software [24]

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Ken, I'll start with you. Just with regards to SD-WAN, tremendous momentum there. I wanted to understand, just from a strategy perspective how you are pitching the SD-WAN value proposition to your telco and service provider and carrier partners because to some extent, the secure SDN proposition is counter to some of the other areas of telco's businesses like the MPLS stream. So I wanted to better understand what your strategy is with telcos. And then I have a follow-up for Keith, if I may.

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Ken Xie, Fortinet, Inc. - Founder, Chairman & CEO [25]

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Yes, it's a lower total cost of ownership, especially we have a 1 box solution compared to some other network vendor, whatever. They need to have 2, 3 box. One for SD-WAN, one for security, one for networking. And so we have all this integrated in a single box. And also, because the huge computing power comes from our SPU, security process unit, so we can easily outperform and add additional function, combining all the security network function together. And still like -- easily like a 3- to 30x faster than other like a single SD-WAN function box or security box. So that's the advantage we have in the technology investment for ASIC chip. Gives us huge computing power, not just for the SD-WAN function, but also additional security function, additional network function if we keeping adding there. So that's where the service provider enterprise hugely benefits because for them, whether you're using the box to -- whether service-based revenue of kind of helping lower enterprise total cost. So that's where we see over 70% top-tier service provider offer our SD-WAN solution. So that's where we become a leading vendor. We believe we have the most customer base study adopt our SD-WAN with 21 selling customer -- companies started using our SD-WAN which combined SD-WAN security together.

And also, it's very interesting. So the service we offer with SD-WAN actually is the highest-level service we have. So we do have like a UTM service, an enterprise service, and then we call 360 service which -- like including all the UTM enterprise and class, all the provisional services, including SD-WAN provisioning and management service. So that's where -- so SD-WAN definitely helping drive the additional service, additional security into a lot of new enterprise customer, which we can't -- half the SD-WAN deal has come from new customer which never bought our product before.

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Keith F. Jensen, Fortinet, Inc. - CFO & CAO [26]

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Yes. And I think -- just a follow-up on Ken's comment about the 70 -- 30% of the SD-WAN service providers. I think what we probably saw, particularly in the first half of 2019, was a little bit of hesitation from the carrier and the service providers, and maybe that's related to their MPLS revenue streams. But we've certainly seen a shift in that thinking, I would say, over the last 3 or 4 months.

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Fatima Aslam Boolani, UBS Investment Bank, Research Division - Associate Director and Equity Research Associate Technology-Software [27]

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That's super helpful. And Keith, just for you. You're very specific about the step-up in sales hiring and sort of the higher pace of sales hiring. I'm wondering if you can put a finer point on where these additional sales resources and increased sales capacity is going to be concentrated, whether from the vertical or geographical or even use case perspective. I'd appreciate that color.

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Keith F. Jensen, Fortinet, Inc. - CFO & CAO [28]

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Yes. I think the way I'd probably respond to that question is the way we look at it in terms of adding sales capacity. And there's probably 2 key criteria that Ken and I talk about. One is we want to see somebody who -- a sales leader who's demonstrated performance, that when you give them more resources,that they're going to be able to execute with it; and two, that they want that additional responsibility. Now luckily, we're in a very good position where that crosses geographic lines and it crosses verticals. But I think that's more of the playbook that we're after right now.

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Operator [29]

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Our next question comes from the line of Sterling Auty with JPMorgan.

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Sterling Auty, JP Morgan Chase & Co, Research Division - Senior Analyst [30]

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Ken, I wanted to start out with, as we think about the SD-WAN product road map, especially here in 2020, what are some of the key elements that you would expect to introduce this year that have been missing in the solution thus far?

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Ken Xie, Fortinet, Inc. - Founder, Chairman & CEO [31]

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We're definitely more working closely with the service provider, which we kind of -- are more dominant in the space and offer a lot of managed SD-WAN service and also a lot of channel partners, having more working with us, especially system integrators -- the big global system integrators so they see the benefit of SD-WAN solution compared to their traditional solution.

The other thing we probably -- maybe over -- maybe with a little bit ahead right now is really the NP7, we kind of talked about in Analyst Day. And then later this month, we introduced the first product biodiverse accelerate in Barcelona, which also will change the landscape. This is more like a product starting to go inside the network. So that's where the internal segmentation, the hyperscale, some other part of -- or could be even bigger market than the wide air network, which is SD-WAN we will lead in the last few years.

So that's where there's a few drivers who are keeping -- helping us like the -- I still see more help us more in the SD-WAN in the one side is that integrates seasonal on chip. And then NP7, we're helping on the local area network in a high-speed environment. So that's where we're starting to see the traditional parameter-based network security need to expand into the WAN side and also the LAN side.

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Sterling Auty, JP Morgan Chase & Co, Research Division - Senior Analyst [32]

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Got it. And then, Keith, I apologize, I was bouncing between calls, but -- I apologize if you covered it, but I want to better understand the operating margin guidance here for 2020. And in particular, how much of that impact is coming from the enSilo acquisition versus the increased hiring? And specifically, are you at the end of this maybe increased investment phase? And how does that margin outlook for 2020 fit within your longer-term margin guide?

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Keith F. Jensen, Fortinet, Inc. - CFO & CAO [33]

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Yes, I think very good questions. We tried to cover off in the prepared remarks that a reminder, including the fact that our comment before was that from 2020 through 2022, we expect to average at least 25% operating margin during that 3-year period of time. And that -- first and foremost, that has not changed. The other data point to keep in mind in the commentary was that the M&As that kind of hit in the tail half of the fourth quarter, the drag on operating margin in the fourth quarter was about 0.5 basis point, and the drag for the next year, when we have full quarter operations it's going to be about 1 point of drag. And so one way of looking at it is taking our operating margin at the midpoint and then adding that point back into it.

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Operator [34]

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Our next question comes from the line of Walter Pritchard with Citi.

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

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Question on the subscription side and specifically, pretty good performance on the FortiGuard there. Can you help us understand components of that as you've seen that business accelerate this year? What's been the driver of that trend?

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Keith F. Jensen, Fortinet, Inc. - CFO & CAO [36]

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Yes. FortiGuard -- kind of go back to some commentary from the Analyst Day, FortiGuard is -- about 85% of FortiGuard are bundles, security bundles. You can add to that some standalone security services, if you will. You're also going to get -- when you're trying to model it, you can also get a lag effect of when you see high product sales, say, higher in 2018 than they were in 2017. Those higher product sales in 2018, you're going to attach service contracts which become revenue in 2019. So you're going to get the lift in '19 from the increase in product sales in 2018.

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Walter H Pritchard, Citigroup Inc, Research Division - MD and U.S. Software Analyst [37]

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Got it. Then just a quick one on acquired revenue. How should we think about any contribution from -- you said a small contribution in Q4. Any contribution from the 2 acquisitions in the 2020 number?

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Keith F. Jensen, Fortinet, Inc. - CFO & CAO [38]

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Yes, we've just rolled it in into the total. And I think the comment I gave was it was far less than 1% in the fourth quarter. I don't really see that changing for the balance of -- that I have visibility to in 2020.

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Operator [39]

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Our next question comes from the line of Jonathan Ho with William Blair.

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Jonathan Frank Ho, William Blair & Company L.L.C., Research Division - Technology Analyst [40]

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Just one for me. I just wanted to get your sense of what's happening in the cloud opportunity. You guys mentioned hybrid cloud and sort of the multi-cloud security opportunity. I just wanted to get a sense for what trends you're seeing, particularly for 2020.

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Ken Xie, Fortinet, Inc. - Founder, Chairman & CEO [41]

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Yes, we do see cloud as a part of our February offering. So we gave the customer flexibility whether they wanted to be put on-premise or Google Cloud or their chosen different cloud provider, which they offer -- we offered the same thing like user interface, the same server, how are kind of a solution for them. And also, we're working with cloud provider, service provider well and try to expand in that area. So that's one of the growth drivers for us.

We do believe both cloud and H need to be working together. Solvency is good for cloud, so that's good for the H. So that's where -- the whole solution instead of only focusing on one solution. So that's where we'll be. Like, what are the fabric on the cloud, the H and other. I mentioned like IoT, OT and the 5G or to be kind of working together to make it more secure.

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Operator [42]

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Our next question comes from the line of Michael Turits with Raymond James.

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Michael Turits, Raymond James & Associates, Inc., Research Division - MD of Equity Research & Infrastructure Software Analyst [43]

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On the -- first for Ken, you announced the Fortinet secure SD-WAN on Equinix. So SD-WAN, you said as a full-service. What are your offerings and what is your strategy on a full cloud-based security offering that you would think of that would be analogous to a Zscaler, offering either for local breakout and/or for Zero-Trust network access?

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Ken Xie, Fortinet, Inc. - Founder, Chairman & CEO [44]

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I think they still don't have SD-WAN, and sometimes, we also partner together. And on the other side, like a lot of service provider like Equinix and some others, they do have quite a broad customer base, enterprise customer service provider and leverage their infrastructure. So SD-WAN definitely is a new technology solution can -- like improving the service, lower the cost. And that's where both the service provider, the enterprise customer all like that solution. So that's where we kind of approach from both, one, from end customer angle and with our own marketing force with our BDR resource; and the other one comes from the service provider partner for them to help in -- their customer to improving that service total -- lower total cost of ownership. So that's where we see working with service providers, one of the very important ecosystem for us.

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Michael Turits, Raymond James & Associates, Inc., Research Division - MD of Equity Research & Infrastructure Software Analyst [45]

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And then for Keith, on cash flow. This year, your cash flow grew less than net income this year, in the 20s versus in the 30s. How should we think about it going into next year? Is that just timing that reverses? Should we think about cash flow from ops growing in line with net income or EBIT next year?

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Keith F. Jensen, Fortinet, Inc. - CFO & CAO [46]

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So if you're looking at the cash flow from operations, then you're excluding the real estate, correct? You're not talking about free cash flow, Michael?

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Michael Turits, Raymond James & Associates, Inc., Research Division - MD of Equity Research & Infrastructure Software Analyst [47]

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Not talking about free cash flow, just cash flow from operations.

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Keith F. Jensen, Fortinet, Inc. - CFO & CAO [48]

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Yes, there's -- I don't think -- there's nothing different in terms of modeling it other than just maybe when the quarter ended, how payables got paid and how receivables got collected. And so your premise that -- basically to put words in your mouth, don't look at 1 quarter, but look at it over time, you're right.

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Michael Turits, Raymond James & Associates, Inc., Research Division - MD of Equity Research & Infrastructure Software Analyst [49]

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Right. So in other words, in line with net income or EBIT growth next year is a good guide?

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Keith F. Jensen, Fortinet, Inc. - CFO & CAO [50]

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Yes.

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Operator [51]

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Our next question comes from the line of Rob Owens with Piper Sandler.

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Robbie David Owens, Piper Sandler & Co., Research Division - MD and Senior Research Analyst [52]

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Wanted to drill down a little bit into linearity with regard to 2020. And I know in 2019, we saw very strong back half out of you guys, and obviously, some of the new products in SD-WAN helped there. But you're also making that push up relative to enterprise. So are we seeing the business become a little bit more enterprise back-end weighted? Does that play out in 2020? And what should our initial linearity thoughts be?

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Keith F. Jensen, Fortinet, Inc. - CFO & CAO [53]

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Good question. We spent some time with that actually recently looking at it. And I think if you start looking at 2018's linearity by quarter, that's probably a pretty good idea of what we think -- 2019's linearity. We've got a pretty good idea of what 2020 will look like, at least in terms of how we're modeling internally. So you're probably looking -- book ending the year starting off at, say, at 21% and ending the year in the fourth quarter with maybe 29%, 30% kind of a model. And in between, where our model where Q2 and Q3 tend to be very close together, so you're probably around the 24%, 25% number for both of those.

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Ken Xie, Fortinet, Inc. - Founder, Chairman & CEO [54]

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Here, we also improved the hiring in like second half of 2019 which we hope will be contributing to the 2020 growth. So that's where the salary hiring in like a Q3, Q4, definitely, we'll see some sales starting ramp up to contribute in this year, 2020.

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Robbie David Owens, Piper Sandler & Co., Research Division - MD and Senior Research Analyst [55]

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Great. And then if we look at the large deal metrics, particularly the largest of deals, are these you guys pushing up market into data center situations that are massive or more branch network types of situations? Could you unpack that a little bit for me?

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

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It's more enterprise. That's because a lot of enterprises see the benefit of whether SD-WAN or we call the infrastructure security involved in more product in the fabric. For the fabric also helping to make the deal earlier. So that's where, with most sales, more partner are able to sell multiple product and also the SD-WAN starting to act more like the enterprise. So that's definitely helped increase the deal size.

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Operator [57]

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Our next question comes from the line of Andrew Nowinski with D.A. Davidson.

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Andrew James Nowinski, D.A. Davidson & Co., Research Division - MD & Senior Research Analyst [58]

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So I also want to ask a question on your large deal growth. We saw deals greater than $500,000 and those greater than $1 million with impressive growth again this quarter, yet your high-end appliance revenue lagged with small and midrange appliance growth. So I was just wondering is -- if you could just provide any more color as to why are customers spending more upfront with you since it doesn't look like they're buying -- simply just buying larger appliances.

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Ken Xie, Fortinet, Inc. - Founder, Chairman & CEO [59]

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The new for us are coming. Like I said, it takes us almost 4, 5 years to develop NP7. So that's where we finally released, and the first product will come in later this month. So that will have a huge advantage compared to some old products. So that's where -- that will help.

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Keith F. Jensen, Fortinet, Inc. - CFO & CAO [60]

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Yes. Andrew, this is Keith. A good follow-up question to Rob and to expand on Ken's comment. I think when you look at where the large deals are coming from, I would probably say there's really 3 sources for those. One is the SD-WAN that we talked about. Two is the large distributed enterprise that you're referring to. And then the third is, yes, having success inside the data center and displacing incumbents. And I think each of those are contributing to the growth that we're seeing in million-dollar deals.

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Andrew James Nowinski, D.A. Davidson & Co., Research Division - MD & Senior Research Analyst [61]

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Great. And then just a clarification regarding your gross margin. I know you mentioned the economies of scale as contributing to that, but the guidance for 2020 is a significant expansion from 2019. And I thought that new appliances typically carry a lower gross margin, at least initially. And so given the new appliances you've talked about that are coming out later this month, I was wondering if you could provide any more color as to what might be driving your gross margin higher in 2020, and offsetting that, perhaps initial headwinds you normally face with the new appliance.

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Keith F. Jensen, Fortinet, Inc. - CFO & CAO [62]

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Yes. Keep in mind, we probably have 70 or 80 different firewalls on the price list at any one model at any one point in time. And then also add to that, that when introducing a new product, it doesn't necessarily mean it's going to have a significant revenue impact to a given point or to a given quarter.

I think I wouldn't overplay the new products having an impact on gross margin, unless we're doing a lot of them all at once and they're coming online. I think if you go back to what's actually in the -- to the extent you're talking about product gross margin, and I think you were in your commentary, I made reference to 3 components. One is, I think the indirect benefit is here to stay given the economies of scale. I do believe that the direct benefit, and Ken made reference to it with the ASIC advantage, will continue to manifest itself into our pricing and into our billings. And then thirdly, we now have 2 quarters in a row where -- whether you want to call it, ASP increases or holding line or discounting. I'm not going to commit to say that, that's going to be forever. But I think those are the components that we're looking at in terms of our modeling of gross -- product gross margin going forward.

Lastly, if you're looking at total gross margin, it's really a mix shift as well, where at the moment, we're probably modeling a little more services with higher margin than we are with products at this point in time.

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

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Yes, also with the 2 new SPU, whether the sales -- associate force is on chip working for the NP7, we have a huge computing power enhancement on the 40,000, which also enable us to keep adding other new functions, which can also drive the service, helping like less discount and, let's say, additional huge value added with the same cost. So that also will help improve our margin.

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Operator [64]

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Our next question comes from the line of Dan Ives with Wedbush Securities.

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Daniel Harlan Ives, Wedbush Securities Inc., Research Division - MD of Equity Research [65]

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So my question's specifically on the government vertical. I mean, could you just maybe talk about what's going on there? Obviously, there's a lot of lot transformation going on in deals across, especially on the federal side, where you guys obviously play well. So maybe just talk about that in terms of the composition of deals activity, and just is anything changing on federal?

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Keith F. Jensen, Fortinet, Inc. - CFO & CAO [66]

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Yes, yes. I was reading my email, I saw something this morning from one of our sales people talking about it. Very exciting times are coming in the U.S. Fed. But I think really what you're seeing in our model right now is really diversity in our federal business -- pardon me, in our government business,which includes some benefit from the U.S. Fed but also state, local and international governments.

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Daniel Harlan Ives, Wedbush Securities Inc., Research Division - MD of Equity Research [67]

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Got it. And Ken, could you just hit on 5G? I mean, I know you've talked about it before, but just how you're viewing that over the next 12 to 18 months, and where Fortinet plays in that opportunity.

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Ken Xie, Fortinet, Inc. - Founder, Chairman & CEO [68]

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In which one?

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Keith F. Jensen, Fortinet, Inc. - CFO & CAO [69]

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5G.

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Ken Xie, Fortinet, Inc. - Founder, Chairman & CEO [70]

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5G. I think it's still a little bit early. A certain vertical may be ahead of the consumer, but is -- we're working closely with a service provider, but I see it probably still need a couple of years out to see material impact.

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Operator [71]

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Our next question comes from the line of Patrick Colville with Arete Research.

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Patrick Edwin Ronald Colville, Arete Research Services LLP - Analyst [72]

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Congrats on a seriously impressive quarter and next year's outlook. Can I ask a financial question on the free cash flow to start with? How much are you spending on -- in 2020 for the new campus?

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Keith F. Jensen, Fortinet, Inc. - CFO & CAO [73]

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Yes, the real estate spending will probably run between $150 million and $160 million all in next year.

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Patrick Edwin Ronald Colville, Arete Research Services LLP - Analyst [74]

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Got it, okay, very clear. And then, Ken, can I ask you about ransomware? I do a lot of work speaking to CISOs and CIOs. And in my conversations, that's probably the #1 threat they're facing right now. So I'd love to understand from Fortinet's perspective how at all that may be driving conversations with you guys and your customers.

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Ken Xie, Fortinet, Inc. - Founder, Chairman & CEO [75]

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Yes, that's a very important topic because the majority of attack today now comes from inside. So that's where internal security, internal segmentation, and at the same time, combined with some other like endpoint security, like the company we just acquired, enSilo, some other -- and also -- its very, I think, more and more important. And then also the new NP7 definitely help driving that direction inside our company network, and whether segment different department or server or data source there and even per person. So that will help embed for this ransomware attack.

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Operator [76]

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Our next question comes from the line of Taz Koujalgi with Guggenheim.

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Imtiaz Ahmed Koujalgi, Guggenheim Securities, LLC, Research Division - Director of Technology, Media & Telecom and Analyst [77]

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Had a question on the equities partnership. Can you just talk a bit about the go-to-market there? Will that be sold by Equinix or will that be sold by Fortinet? And how does the rev-rec -- how will the rev-rec work in that case? Would it be still a product or will that be recognized as a service offering?

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Ken Xie, Fortinet, Inc. - Founder, Chairman & CEO [78]

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Probably most starting from go-to-market together, and then we're also working on some other -- more deeper partnership, including certain products that's sort of other service offering. But it's a mark of starting off a good partnership.

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Keith F. Jensen, Fortinet, Inc. - CFO & CAO [79]

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Yes. And I think it's probably just a little bit early to talk about rev-rec. The press release was out just in the last 24 hours. So...

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Imtiaz Ahmed Koujalgi, Guggenheim Securities, LLC, Research Division - Director of Technology, Media & Telecom and Analyst [80]

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So got it. And then just a clarification on the guide. So given that your product revenues were basically -- they grew at the same rate in '18 and '19. Would it be fair to assume that the service revenues -- there's no decline in the service revenue growth in '20? You should basically have the same service revenue growth in '20 that you had in '19?

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Keith F. Jensen, Fortinet, Inc. - CFO & CAO [81]

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I think we actually included in the guidance service revenue for the year, so I think that will probably give you a pretty good visibility to it in the prepared comments.

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Operator [82]

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Our next question comes from the line of Chaim Siegel with Elazar Advisors.

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Chaim Siegel, Elazar Advisors, LLC, Research Division - Analyst [83]

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I noticed the -- obviously, the billings number was much higher than you thought, and I'm just wondering what was the components behind that.

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Keith F. Jensen, Fortinet, Inc. - CFO & CAO [84]

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I think we saw a very good performance in many, many geos. I would count the U.S. as being a very, very strong geo. We also did very well in our emerging markets in the quarter. It was strong -- I gave you the revenue number, which is a pretty good indicator. But I think, really, if I were to call out in terms of where the strength was in the quarter, I was very pleased with the U.S. and our emerging markets.

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Chaim Siegel, Elazar Advisors, LLC, Research Division - Analyst [85]

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Congratulations.

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Keith F. Jensen, Fortinet, Inc. - CFO & CAO [86]

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And I should -- pardon me, I got to mention on the TAM also we did a great job again. I'm going to get in trouble, and they did a very good job.

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Operator [87]

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Our next question comes from the line of Nick Yako with Cowen.

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Nicholas Andrew Yako, Cowen and Company, LLC, Research Division - VP & Senior Analyst [88]

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Great. I wanted to ask about fabric. I'm just wondering if you can provide any color around the percent of FortiGate customers that have deployed a fabric product and then maybe how that's trended over the past few years.

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Keith F. Jensen, Fortinet, Inc. - CFO & CAO [89]

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I think there's -- if I'm understanding the question correctly, I think there's a very high correlation between fabric customers and FortiGate products. It's fairly unusual for us to sell a fabric product to somebody who's not a FortiGate product customer.

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Nicholas Andrew Yako, Cowen and Company, LLC, Research Division - VP & Senior Analyst [90]

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Right. Okay. And can you tell -- helpful color around the SD-WAN contribution in 2019. Any color on what that contribution was in 2018?

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Keith F. Jensen, Fortinet, Inc. - CFO & CAO [91]

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Very, very small. I don't -- low single digits at best, probably.

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Operator [92]

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This concludes today's question-and-answer session. I would now like to turn the call back to Peter Salkowski for closing remarks.

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Peter M. Salkowski, Fortinet, Inc. - VP of IR [93]

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Thank you, Sarah.

I'd like to thank everyone for joining the call today and let you know that Fortinet will be attending the following investor conferences in San Francisco during the first quarter. We will be at the Goldman Sachs conference next week on February 11, and we'll be at the Morgan Stanley conference also in San Francisco on March 3. Presentations for both of these events will be webcast, and links to these webcasts will be available on the Investor Relations website for Fortinet.

If you have any follow-up questions, please feel free to contact me. Have a great rest of your day. Thank you.

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Operator [94]

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Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect.