The speaker, Peter Salkowski, welcomes everyone to the Fortinet Q2 '23 earnings call and introduces the other speakers. He explains that the call will be recorded and available for replay on the Investor Relations website. He then goes on to explain that Ken Xie, Fortinet's Founder Chairman and CEO, will begin the call with a high level perspective of the business, followed by Keith Jensen, the Chief Financial Officer, who will review the financial and operating results for Q2 and provide guidance for Q3 and the full year. Finally, the call will open for questions, with a reminder that forward-looking statements may be made and are subject to risks.

In the second quarter of 2023, Fortinet's total revenue increased 26%, driven by strong service revenue growth of 30%, with existing subscription and non-FortiGate product growth of 45%. According to IDC's latest quarterly security tracker, Fortinet is the number one unit and revenue leader in the firewall category, and is also one of the top and fastest growing OT security vendors in the market, according to Westland Advisors.

Fortinet has increased their go-to-market investment in universal setting for IoT security, cloud security, and security operations. They have announced the FortiGate 90G, a next generation firewall with industry-leading security functions, performance, stability, and power efficiency. They have also announced two new SD-WAN services to simplify operations and enhance digital experience. Fortinet plans to accelerate their global point of presence deployment with a dual strategy of investing in their own and working with service providers.

Fortinet recently announced the results of their IT-dependent analysis which showed a 300% return on investment over three years, pay back in six months and 90% reduction in time spent on manual updates. An independent analysis by Enterprise Strategic Group showed a reduction in time to detect and respond to incidents from three weeks to one hour. AI technologies are being used to improve productivity and can be scaled to a large customer base for malware detection, thread hunting, event correlation and automation, as well as safety network design and troubleshooting. In the second quarter, there was an 18% growth in billings, a 30% growth in service revenue, and a total revenue growth of 26%. Operating margins were 26.9%.

Free cash flow was strong at $438 million in the quarter, with non-FortiGate billings up 30% and government and manufacturing topping the list of industry verticals. Revenue grew 26%, with product revenue up 18% and service revenue up 30%. Total gross margin was 77.9%, with product gross margin up 160 basis points due to earlier pricing actions. Deals over $1 million increased from 122 to 134.

In the quarter, service revenues were 63% of total revenues and delivered a gross margin of 86.2%. Operating income grew 36% outpacing revenue growth, resulting in an operating margin of 26.9%, and earnings per share increased 58% to $0.38 per share. Free cash flow increased 55% to $438 million, and the board recently increased the company's share repurchase authorization by $500 million. The paragraph also highlights some significant wins from the quarter.

Fortinet has recently signed multiple deals with customers for their cybersecurity solutions. These include securing medical data for a global pharmaceutical leader, providing a NAC solution to one of the largest U.S. school districts, and delivering a SASE solution to a large bank for their hybrid workforce. These deals demonstrate customers' interest in Fortinet's platform strategy, integrated operating systems, and proprietary ASIC technology, as well as their investments and innovations in AI.

Fortinet has been using AI and machine learning for many years, and has implemented it in their virtual FortiGuard Threat Analyst. This AI-driven threat intelligence is used to detect threats and generate updates for the Fortinet security fabric and ecosystem. Fortinet continues to invest in AI and machine learning technologies such as generative AI, natural language models, and other implementations to enhance, simplify and automate security. It is believed that macroeconomic factors have impacted the second quarter's billing performance and enterprise deal pushing.

Fortinet has seen shorter contract durations, creating a billings headwind. CIOs are investing in cybersecurity, providing market tailwinds, and Fortinet expects to see more normal seasonality in the back half of the year. For the third quarter, Fortinet expects billings to grow 13%, revenue to grow 17%, gross margin of 75.5-76.5%, and operating margin of 24.5-25.5%.

This paragraph provides guidance for the company's financial performance for the full year. Expected billings are in the range of $6,490 million to $6,590 million, revenue in the range of $5,350 million to $5,450 million, and service revenue in the range of $3,350 million to $3,410 million. Non-GAAP gross margin is expected to be between 75.25% to 76.25%, non-GAAP operating margin between 25.25% to 26.25%, and non-GAAP earnings per share of $1.49 to $1.53. Capital expenditures are estimated to be between $335 million to $385 million, and the non-GAAP tax rate is expected to be 17%. The company is confident in its long-term strategy and expects billings growth to approach high-teens by the fourth quarter of 2024.

Ken Xie and Keith Jensen discussed the service provider industry and how it is behind in terms of offering security services. They noted that they are investing in infrastructure to help drive new security services and accelerate security service beyond traditional services. They also highlighted that the manufacturing industry did very well in the quarter, providing lessons for other customer segments.

Ken Xie discussed the cloud provider getting into the security space, which is confusing for enterprise customers. This hybrid approach of on-premise and cloud is likely the best solution, even though it is more expensive. Keith Jensen mentioned that the company expects to see a reinflection to high teens billings growth next year, which impacts their 2025 $10 billion billings target.

Keith Jensen and Ken Xie discussed the network security industry and the unique advantages that their product has. They mentioned that their product has 14 application engines integrated into the ASIC chip, which is more than double the previous version, and has 10x better performance and 90% less energy consumption. They also plan to announce a new product every quarter, which will help to drive growth in the next few quarters.

In the last two or three years, the company has had to be nimble when setting their guidance for Q3 and Q4. In June, there was a new development of deals pushing to the latter part of the month. This will be taken into account when setting the Q3 guidance. The assumptions for Q3 are to close deals at certain rates and terms.

Keith Jensen cautions that Q4 billings growth may be lower than usual due to a difficult comparison to the strong Q4 of last year. Ken Xie adds that there are still areas of growth such as SD-WAN OT and 5G which could help offset this. Gabriela Borges suggests that Q4 may be the trough for billings growth, and Keith Jensen recommends looking at the financial presentation #10 page for more information on growth over the past 13 years since the company's IPO.

Tal Liani asked two questions: why Palo Alto and FireEye's weaker than expected results could be attributed to a deteriorating market environment, and why FireEye's guidance suggests a continued deceleration into 3Q and 4Q if there were pushouts. Keith Jensen answered that he had seen pushouts in the quarter and was happy with the deals closed in July, but that he was not expecting a quarter-to-quarter recovery in the pushouts.

Ken Xie is discussing the current state of the economy and how it is impacting the security industry. He notes that large companies are being more tight with their budgets and taking longer to close. He also notes that security is an underspend, but that companies are leveraging their current solutions and buying more services. He believes that Fortinet will continue to lead the industry in product revenue and unit shipments. He is focused on the long-term convergence of network to network security and believes that Fortinet has the best technology products to meet the challenge.

Ken Xie has stated that the backlogs have returned to normal and that the majority of the supply chain issues have been solved. Keith Jensen has added that the company will have a low single-digit benefit in Q3 and that by the end of Q3, they will be close to normal backlog numbers.

Ken Xie states that Fortinet is still gaining market share, and that consolidation of the market is helping to leverage their installation base. Xie also mentions that there is some inventory being held by customers and partners, and that Fortinet has changed their service grace period policy to 90 days to help reduce the inventory level. Lastly, Xie mentions the new ASIC SP5 product that offers four to five times better performance at the same cost.

Keith Jensen and Ken Xie discussed the win rates for the top 3 competitors in the firewall market, which have been consistent or improved, though there were deals that were expected to close that did not. Xie noted that the regional slowdown is due to strong growth in years prior, and Zelnick asked about pricing trends as supply constraints ease. Jensen responded that their approach for new products is to introduce them, and discussed the 90G product.

In the second half of the year, the company plans to take targeted pricing actions, such as discounts, rebates, and incentives for channel partners, to participate in the low-cost franchisee market. Last quarter, cancellation rates were in the high single digits, and this quarter they are in the low double digits. Over 25% of revenue came from SD-WAN and OT security, with 40% from SD-WAN and 60% from OT.

Ken Xie discusses the advantages of telecom service providers and cloud providers in the SASE market. He mentions that they have a cost advantage and are able to offer additional security services. Xie also mentions that Fortinet is investing in infrastructure and services like SD-WAN, FortiGuard, and FortiCare to make their services more profitable and cost-efficient. Keith provides commentary on the billings duration in the quarter.

Keith Jensen and Saket Kalia discussed billings duration for the second half of the year and how it could affect year-over-year growth. Ken Xie added that SASE is especially important as companies start to return to work and the office. They concluded by discussing how the results from Q2 and the assumptions made for the guidance setting process could heavily influence the billings duration.

The company sees a lot of demand for universal SASE that supports both on-premise and remote work, as well as for single-vendor SASE solutions and private SASE solutions. They have seen some release from exclusive networks and their biggest distributor accounts for 30% of their business.

CISOs face a difficult job due to the limited budgets and threats they must manage. Despite this, they still have to secure their infrastructure, both on-prem and in the cloud. As the year progresses, the company will go through its planning cycle more rigorously to plan for 2024.

Ken Xie and Joseph Gallo discussed the need for companies to invest in hiring to support the hybrid work environment, as well as the need for new infrastructure and technologies such as AI and OT security. They also talked about the need for companies to commit to cloud spending and security budget in order to better support the hybrid work environment. They concluded by discussing how companies should think about investments in hiring as they work through the digestion period.

Ken Xie and Keith Jensen discussed the need to invest in growth and productivity while maintaining a healthy model with a 25% operating margin. They also discussed the need to invest in channel partners over the next 6-12 months and referred to Page 10 of their report which showed a 13 year gross margin and three year GAAP profit since their IPO.

Andrew Nowinski from Wells Fargo asked about the geographic demand trends and the sustainability of the demand in Europe. Keith Jensen said that they have a competitive advantage in Europe due to their dominant market share. He also said that IT budgets are currently lower in the US than in Europe. Andrew then asked about Fortinet's competition with Microsoft's Entra solutions for the SMB segment. Ken Xie said that they leverage their installation base and their technology to address network security, and that there was an opportunity for both companies. The question and answer session then concluded.

Peter Salkowski thanked everyone for joining the call and announced that Fortinet will be attending investor conferences hosted by Deutsche Bank, Goldman Sachs, Oppenheimer, Rosenblat and Stifel during the third quarter. He invited people to contact him with any follow-up questions and concluded the call by thanking everyone again. The operator then concluded the call.

This summary was generated with AI and may contain some inaccuracies.