The call is for the Fortinet Q3, 2023 earnings announcement and is being recorded. Peter Salkowski, Senior Vice President of Investor Relations, introduces Ken Xie, Fortinet's Founder, Chairman and CEO, and Keith Jensen, Chief Financial Officer. Ken will provide a high-level perspective on the business while Keith will review financial and operating results for the third quarter and provide guidance for the fourth quarter and full year. The call will then be open for questions. Forward-looking statements will be made, but they are subject to risks and uncertainties.

In the second paragraph, the speaker discusses the financial metrics and references to them being non-GAAP. They also mention that the GAAP results and reconciliations can be found on the Investor Relations website. The remarks from the earnings call will also be posted on the website. The speaker then turns the call over to Ken, who talks about exceeding street expectations in operation margin and free cash flow. However, there was a slowdown in secure networking growth and challenges in sales execution and marketing efficiency. To address this, the company is shifting its focus towards the faster-growing SASE market while maintaining its leadership in secure networking. The secure networking market is valued at $62 billion and is expected to grow to $86 billion by 2027.

Fortinet's focus on providing industry-leading DOS and ASIC-driven performance has led to increased market share. The company is also innovating in the growing segment of secure operations and SASE, with a comprehensive and integrated platform. Fortinet's strength lies in its innovation and ability to enable automation through product integration, including AI-powered automatic stock business. The company is also increasing its focus on SASE, with a solution that can perform all functions in the cloud and on-premises using its ASIC technology.

The company is confident in its SASE offering, which includes various services such as SD-WAN, firewall, and secure computing. They expect to see success by upselling to their existing customer base and attracting new customers. Their leadership in firewall and SD-WAN gives them a competitive advantage. While they anticipate modest growth in the next few quarters, they expect double-digit growth in the second half of 2024. The company remains committed to generating healthy operating margins. They are shifting their focus towards the faster-growing SASE and SecOp markets, which currently make up 20% and 10% of their business respectively and are expected to grow in the mid- to high teens annually.

In the near term, Secure Networking, which makes up 70% of the business, is expected to have slower growth. However, the company plans to maintain healthy profitability and return to mid- to high-teen top line growth through investments in SASE and SecOps markets. The quarter saw strong performance in new logo additions, small enterprise and software, as well as higher operating margin and free cash flow. Billings grew at a CAGR of 26% over the past 3 years, but in Q3 there was only 6% growth due to shorter contract duration and lackluster appliance demand. Education and government sectors were strong, while service provider and retail sectors were weak. Small enterprise billings grew, but larger enterprise growth rates were lower than expected.

In the sixth paragraph, the company discusses Phil's growth in different regions, with international emerging markets showing strong growth while Europe and the U.S. were weaker. Total revenue grew by 16%, with product revenue down 1% due to product lead times and lower demand for network security. Service revenue accounted for 65% of total revenue, with a 28% growth driven by higher-margin security subscriptions. Gross margin was 76.9%, up 70 basis points, and operating margin exceeded expectations. The company also mentions its efforts to control spending and provides a summary of the cash flow statement.

In the third quarter, the company saw a 22% increase in free cash flow and a 41% increase in operating cash flow. They also made real estate investments and paid $26 million in cash taxes. The company repurchased $605 million worth of stock and has remaining authorization for $980 million. They also had two significant wins in the SASE market, including a 7-figure upsell and a 6-figure deal with existing customers. These deals were made before the company's partnership with Google Cloud and their recognition as a challenger in Gartner's SASE Magic Quadrant. It is predicted that by 2025, a third of new SASE deployments will be made with a single vendor.

Fortinet is recognized in 9 Gardner Magic Quadrants and is making strategic investments in research and development and solution delivery to focus on SASE and SecOps. This includes partnerships with Google Cloud, integration of single SASE features into their products, and expanding SecOps capabilities with AI technology. They are also actively promoting their position in the SASE Magic Quadrant and certifying sales professionals in SASE and SecOps. Additionally, they are investing in sales comp plans and expanding partner roles to focus on SASE and SecOps. Fortinet believes they are well positioned in the cybersecurity market and the trend towards platform strategies is still in its early stages.

Gartner reports that 75% of companies are adopting a vendor consolidation strategy in the cybersecurity industry, leading to increased interest in integrated security solutions like Pertinent's. However, longer sales cycles and budget scrutiny are impacting the company's near-term results, and their fourth quarter guidance takes this into consideration. The company expects a decline in billings but growth in revenue, with a non-GAAP gross margin of 75.5% to 76.5% and non-GAAP operating margin of 27.5% to 28.5%. Non-GAAP earnings per share are projected to be $0.42 to $0.44, with a share count of 780 million to 790 million, and capital expenditures of $40 million to $60 million. The non-GAAP tax rate is 17% and cash taxes are $345 million.

In the full year, the company expects billings of $6.095 billion to $6.235 billion, representing a 10% growth. Revenue is expected to be in the range of $5.270 billion to $5.330 billion, with a midpoint growth of 20%. Service revenue is expected to grow by 28% at the midpoint, implying a product revenue growth of 9%. The company also expects a non-GAAP gross margin of 76% to 77%, non-GAAP operating margin of 26.5% to 27.5%, and non-GAAP earnings per share of $1.54 to $1.56. In the long term, the company plans to focus on improving profitability and gradually increasing billings growth. They also remain confident in their solutions and ability to adapt to market shifts.

During the Q&A session, the operator reminds participants to limit themselves to one question and one follow-up question. The first question is from Hamza Fodderwala from Morgan Stanley, asking if SASE is starting to cannibalize the firewall market. Ken Xie responds that SASE is a different business model, with a focus on service-based OpEx. The next question is from Brian Essex from JPMorgan, asking about the trajectory of product declines and what observations can be made from past spending cycles. Keith Jensen responds that they are confident in their ability to return to double-digit growth in the second half, with easier comps.

The speaker responds to a question about the cyclical nature of the company's business and mentions a new slide in the investor presentation that outlines past volatility and future growth potential. The CEO adds that they believe the convergence of network and network security will continue to drive market opportunity, and the company's unique advantages position them well for gaining market share. The next question is from an analyst at Citi.

In response to a question about the weak buying patterns in the service provider and retail verticals, Keith Jensen, a company spokesperson, explained that the slowdown in these areas was unexpected, especially in the worldwide service provider market. He also noted that the retail sector may be experiencing a slowdown due to the digestion of SD-WAN projects and economic concerns. Another question was raised about the company's focus on non-appliance sales in the past and whether the slowdown can be attributed solely to appliance sales.

The speaker is discussing the company's exposure to appliance sales and how they are related to other successful products like SD-WAN. They mention a new product launch and how it will improve performance and cost. They also mention a potential refresh cycle for appliances in the future.

Ken and Keith discuss the impact of the combination of products on sales, and believe that things will return to normal in the second half of next year. They mention that their first sales to customers are usually firewalls, but they are now investing more in SecOps products like EDR and SIM. Saket asks when Fortinet will have a solution that can compete with other SASE solutions.

The speaker asks two questions about the company's performance. The first question is about the potential growth of a certain part of the business and the second question is about the company's profitability in the future. The response is that the company is currently ahead of its competitors and has a unique solution that offers both cloud and on-premises options. The company has been reinvesting its profits into R&D and go-to-market strategies, and is currently looking at its sales coverage.

The speaker discusses the company's focus on SASE and security operations and acknowledges their advantage in having a strong installed base. However, they also mention changes in distribution, both direct and indirect, and the need for investment in sales enablement. The speaker questions if the same level of sales productivity can be achieved in this new distribution model compared to the previous box-centric approach.

Ken Xie, CEO of Fortinet, believes in the fast-growing SASE SecOps market and is focused on sales training, restructuring, and efficient marketing. The company is also working closely with channel partners to reach a broader customer base and sees a large cross-sell opportunity. The investment made in the past will not slow down the company's expansion in the service-based SASE market and consolidation of secure approaches. Keith Jensen, COO, adds that the company has already done several hundred SASE deals in the past 2 quarters without much marketing support, and they have seen a mix of new customers, SD-WAN customers, and customers using Fortinet's solution for other firewall use cases.

The speaker believes that the company's investments in data centers, PoPs, and partnerships have positioned them well for the SASE market. They have a good partnership with Google and also have their own data centers and PoPs. The company has realigned the market into three segments: secure networking, SASE, and SecureOp, which they believe better aligns with customer needs.

The speaker is confident in the company's profitability and free cash flow. They have a strong balance sheet and are considering potential M&A opportunities to accelerate their pivot towards universal SASE and SecOps in response to market trends.

The speaker discusses the potential for share repurchases and using the balance sheet as a weapon during a time of pressure on the business and stock. He mentions the available authorization for buybacks and the company's aggressiveness in buying back stock. The speaker also mentions the possibility of looking for other companies to join forces with, as well as the importance of internal innovation. In response to a follow-up question about supply and inventory, the speaker mentions potential product gross margin pressure and the need to manage inventory in light of current demand.

In the paragraph, Keith Jensen and Ken Xie discuss the company's inventory levels and how they have been managing them. They mention that they aim to keep about 6 months' worth of inventory and have been handling it well compared to their competitors. They also address sales execution issues and steps they are taking to address them. They briefly mention a new SASE partnership and mention that they have been growing their business and hiring more salespeople in the last 2-3 years.

The company is working to improve their supply chain and sales performance, and is focusing on becoming more efficient in both areas. They have received positive feedback on their recent partnership and plan to continue working with other partners while also investing in long-term strategies. The company's qualitative guidance for 2024 billings is for double-digit growth, which is a slight decrease from the previous quarter's expectation of high teens growth.

An unidentified analyst asks a question about the company's forward-looking billings growth for 2024. The CEO responds that they have adjusted their expectations to be more conservative due to the third quarter's performance. The next question is directed towards the CFO and asks about the methodology behind the company's top line guidance. The CFO explains that their assumptions for close rates have decreased and that there are indicators that the pipeline quality is better for the fourth quarter.

The speaker believes that the low close rate in the past 2 quarters should not be given much importance. They are not providing guidance for 2024 and instead focusing on the impact of backlog on billings in Q1 and Q2 of last year. They do not expect a significant growth in bookings for 2024, but anticipate improvement with the implementation of SASE and secure operations. The speaker also discusses the role of AI in security, stating that it will continue to drive growth in both cloud and appliance security. They see long-term growth in the convergence of networking and security, with their integrated ASIC giving them a competitive advantage. They do not foresee a slowdown in appliance sales for cybersecurity.

The operator introduces a question from Gray Powell from BTIG about the breakdown of billings and growth rates for secure networking, SASE, and SecOps. Ken Xie, the CEO, responds by stating that they are growing faster than the market in all three segments and that there is more headwind in AP switch due to supply chain issues being resolved. The next question comes from Eric Heath from KeyBanc Capital Markets, who asks about the economics of customers switching from firewalls to SASE and the impact on annualized billings and free cash flow. Keith Jensen, the CFO, responds that the shift away from firewalls may result in a shift to annualized billings and discusses the impact on free cash flow.

The speaker discusses the impact of SASE on Fortinet's business, stating that it will take time for significant changes to be seen in their firewall business due to their large footprint. They mention a decrease in contract term and the impact on financials. They also mention training for their sales force and potential for upselling to their installed base. The speaker concludes by thanking listeners and mentioning upcoming investor conferences.

The operator is ending the conference call and thanking the participants for participating. They can now disconnect from the call.

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