Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

Fortinet, Inc. (NASDAQ:FTNT)

Q1 2014 Earnings Conference Call

April 23, 2014 16:30 ET

Executives

Michelle Spolver - Vice President, Corporate Communications and Investor Relations

Ken Xie - Co-Founder, Chairman and Chief Executive Officer

Drew Del Matto - Chief Financial Officer

Analysts

Brent J. Thill - UBS

Melissa Gorham - Morgan Stanley

Sterling Auty - JPMorgan

Jonathan Ho - William Blair

Gray Powell - Wells Fargo

Daniel Ives - FBR

Aaron Schwartz - Jefferies

David Kaplan - Barclays

Jayson Nolan - Robert Baird

Shaul Eyal - Oppenheimer

Jim Fish - Citi

James Wesman - Raymond James

Robert Breza - Sterne

Sanjit Singh - Wedbush

Erik Suppiger - JMP

Operator

Good day, ladies and gentlemen, and welcome to your Fortinet Q1 2014 Earnings Announcement. At this time, all participants will be in a listen-only mode, but later there will be a chance to ask questions and instructions will be given at that time. (Operator Instructions) And as a reminder, today’s conference is being recorded.

And now, I would like to turn it over to your host, Michelle Spolver.

Michelle Spolver - Vice President, Corporate Communications and Investor Relations

Good afternoon, everybody and thank you for joining this conference call to discuss Fortinet’s financial and operating results for the first quarter of 2014. Joining me today are Ken Xie, Fortinet’s Founder, Chairman and CEO and Drew Del Matto, CFO.

In terms of the structure of the call, Drew will begin with a review of our operating results before turning the call over to Ken to provide additional perspective on our business and product advantages. Drew will then conclude with some thoughts on our outlook for the second quarter and comments on the full year 2014 before we open up the call for questions.

As a reminder, today we are holding two calls. For those who have additional or more detailed questions, we are holding a second call at 3:30 PM Pacific Time. Both calls will be webcast from our Investor Relations website and will be accessible as detailed in our earnings release.

Before we begin, let me first read this disclaimer. Please note that some of the comments we make today are forward-looking statements. These forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those projected in these statements. Please refer to our SEC filings; in particular, the risk factors described in our Forms 10-K and 10-Q for more information. All forward-looking statements reflect our opinions only as of the date of this presentation and we undertake no obligation and specifically disclaim any obligation to update forward-looking statements. Also please note that we will be discussing certain non-GAAP financial measures on this call. Our GAAP results and GAAP to non-GAAP reconciliations can be found in our earnings press release and on Slides 15 and 16 of this presentation that accompanies today’s remarks.

Please refer to our Investor Relations section of the website at www.investor.fortinet.com for more important information, including our earnings press release issued a few minutes ago and the slides that accompany today’s prepared remarks. A replay of this call will also be available on our website through April 30. Note that we routinely post information on our website and we encourage you to make use of that resource.

Before Drew discusses our key financial and operating results for the first quarter, I want to point out that we are making a slight change in revenue classification metrics and specific pro forma items with the goal of simplifying financial disclosure and conforming to more standard reporting practices. Beginning in the first quarter of 2014, these pro forma items will now and going forward include stock-based compensation expense, charges related to acquisitions and other significant non-recurring items.

There was a minimal positive impact of 0.3% to non-GAAP operating margin, but no impact on the total amount of revenue, non-GAAP gross margins or non-GAAP EPS we are reporting for the first quarter. We are simply reclassifying how we categorize certain revenue items and simplifying our pro forma items to make our reporting simpler and easier to bridge GAAP to non-GAAP reporting.

With that, let me now turn the call over to Drew.

Drew Del Matto - Chief Financial Officer

Thank you, Michelle and thank you to everyone for joining us today. I am pleased to say that Fortinet had a very strong first quarter and we outperformed on billings, revenue, gross margin, free cash flow and net income. Our billings for the first quarter were $188 million significantly exceeding our guidance and increasing 26% year-over-year. Total revenue was $169 million, up 24% and also above the high end of our guidance. From a profitability perspective, non-GAAP operating margins were 16% and non-GAAP EPS was $0.11 both also well above our guidance.

As Michelle mentioned, our non-GAAP EPS was not affected by the change of pro forma items that we are making this quarter, which I will discuss in more detail in a moment. Non-GAAP gross margins were 71%, which was at the high end of our guided range. Additionally, our cash generation was strong as evidenced by the $50 million of free cash flow, which includes the $20 million Palo Alto networks paid us for a mutual covenant not to sue and release agreement. Finally, during the quarter we repurchased roughly 335,000 shares of our stock returning approximately $7.5 million to shareholders as part of our share repurchase program approved last December.

Our strong first quarter results reflect our focused execution, increased investment in sales and marketing and strengthened technology advantage. We continue to gain market share and increase our competitive position. In particular, we are winning a growing number of large enterprise data center security deals with the number of deals over $500,000 in Q1 increasing 146% year-over-year. Similar to what we saw in Q4 of last year, our increased investment in sales and marketing, as well as our ongoing superior innovation and product development, continued to pay off. Increased marketing campaigns and customer adoption of recently announced products helped contribute to our strong quarterly results. We made the strategic decision to invest more for growth and to capitalize on our market opportunity. We believe that these investments are now paying off, with our second quarter of accelerating growth.

Let me take a moment to discuss the accounting changes Michelle mentioned in her opening remarks. Effective in Q1, we have changed our policy for calculating non-GAAP operating income and non-GAAP diluted net income per share to conform to more standard practices and to simplify reporting for investors. The new policy will be used to calculate non-GAAP operating income and non-GAAP diluted net income per share beginning with our fiscal quarter ended March 31, 2014.

As Michelle stated, we define non-GAAP operating income as operating income plus stock-based compensation expense, acquisition-related charges, including amortization impairment and other purchase accounting adjustments, and any other significant nonrecurring charges. This change in non-GAAP policy will have the impact of not excluding the patent sale licensing and settlement related income from operating income and diluted net income per share as an adjustment to calculate our non-GAAP financial measures. And to reiterate, the changes have no impact on reported revenue or gross margin.

Let me now dive deeper into our Q1 results, which can be seen on Slide 3. Billings were $188 million during the first quarter, an increase of $39 million or 26% year-over-year and well above our guided range of $168 million to $173 million. From a geographic perspective, year-over-year billings growth was an impressive 36% in the Americas and 31% in EMEA. APAC billings grew modestly at 6%, in large part due to a tough comparison to last year.

We were especially pleased with the continued momentum in the Americas where we expanded our penetration in the large enterprise market, winning numerous data center firewalls and next-generation firewall deployments. We also saw good growth in the mid-sized enterprise market, in large part, the result of our diligent focus on building and enhancing partnerships with large national resellers that serve these markets. Business with national enterprise focused channel partners increased solidly year-over-year. And finally, we experienced a solid performance in our service provider segment and in Latin America, both of which appeared to return to more normal spending patterns than we saw during the first half of last year.

With regards to EMEA, we had another quarter of solid execution, as all of the sub-regions executed well, with especially strong performance from Central Europe, the U.K. and the Middle East. We continued to succeed in selling our FortiGate appliances and FortiGuard subscription services to enterprises and service providers, and we also had good traction with our non-FortiGate products especially on FortiWeb Web application firewalls and FortiMail e-mail security appliances.

Lastly, regarding APAC, our billings growth rate was impacted by a difficult comparison against the strong Q1 last year. We did, however, see strong performance from Japan, the region’s largest contributor, where we closed some significant deals with large enterprises and service providers. Southeast Asia and China also performed well. Evidence of our success in penetrating large enterprise and service provider markets can be seen in the large number of deals closed during the first quarter. Deals over $100,000 grew 45% to 247 from 170 in the same period last year. Deals over $250,000 grew 42% to 78 compared to 55 last year. And deals over $500,000 grew an impressive 146% to 32 compared to 13 last year. We also had several deals over $1 million, and that number grew year-over-year as well. Our key vertical breakdown across the enterprise remained relatively consistent with service provider at 26%, government at 10%, financial services at 2%, education at 6% and retail at 6%.

Now, turning to billings by product segment on Slide 4, we continue to see diversity of product billings across all segments, with high-end FortiGate products, which are typically sold to large enterprises and service providers, accounting for 37% compared to 30% last year; mid-range enterprise products accounting for 25% compared to 32% in Q1 of last year; and entry-level products, which typically are deployed in enterprise branch offices and SMBs, accounting for 38%, the same percentage year-over-year. And as a reminder, our product billings mix varies quarter to quarter based on the composition of products in our deals. I also want to point out that similar to Q4, the percentage mix of entry-level products was slightly skewed at the low end again, primarily due to several large service provider deals where a high number of entry-level products were purchased and deployed at a customer’s site versus as a managed security services delivered via the cloud.

With regard to revenue, during the first quarter, total revenue was $168.9 million, up 24% year-over-year and well above our guided range of $155 million to $159 million, driven by strong new product sales in the quarter. As a result, product revenue increased 32% year-over-year. New product sales typically generate recurring revenue through our platform of FortiGuard security subscriptions, reflecting the adhesion of our offering with our customers.

On a geographic basis, you can see on Slides 5 and 6 that revenues continue to be diversified globally, which remains a key strength of our business. Our strongest year-over-year revenue growth came from the Americas which grew 38% to $72.4 million and now comprises 43% of total revenue.

Some key deals in the Americas region included a seven-figure data center security deal with one of North America’s largest telecommunications companies. This company is a large, existing customer using numerous Fortinet products to protect its own infrastructure and deliver an array of managed security services to their customers. During Q1, they purchased several high-end FortiGate-5000 chassis appliances to use as high-performance, low-latency firewalls to support their data center expansion and increase capacity and bandwidth requirements.

We also had a seven-figure win during the quarter with a large U.S. federal government agency that required a high-performance data center firewall solution to enable it to securely share services with other government entities. The deal included deploying our high-end FortiGate-5000 products in two data centers as well as our FortiManager and FortiAnalyzer large-scale management and analysis appliances along with professional services. We beat out Palo Alto Networks, CheckPoint, Juniper and Cisco due to our superior performance capability as well as our ability to provide the lowest total cost of ownership.

And finally, we won a large enterprise data center firewall deal with one of the biggest software companies in the world. This customer chose our newly-introduced FortiGate 3700D high-end appliances to protect their bandwidth-intensive content delivery network. After extensive testing, we won this deal against CheckPoint based on the unmatched raw performance and price performance our products deliver. Our products are now used to provide next-generation network security to two of the world’s largest software companies, illustrating the strength of our offerings with discerning technology-savvy enterprises.

Now, turning to EMEA, revenues were $56.6 million, up 20% compared to $47.3 million last year. Some key deals included a greater than $500,000 deal with a large European government agency which is building out its next generation network to help improve security and connectivity and encourage shared services between government agencies. The deal included numerous Fortinet appliances, Fortinet products, including our new FortiGate-1500D enterprise next-generation firewall appliances, FortiMail e-mail security appliances, FortiAuthenticator-3000D secure authentication appliances, and our FortiManager and FortiAnalyzer management and analysis appliances. We beat Cisco, CheckPoint, and Juniper for this deal based on our ability to meet an array of complex security requirements via our broad platform of network security products.

Additionally, we expanded our footprint within a key financial services customer in Europe that ranks among the world’s top banks. In this competitive six-figure deal against CheckPoint, Fortinet’s enterprise high-end FortiGate appliances were selected to protect thousands of the ATM machine transactions. Obviously mission-critical in nature, security effectiveness, reliability and customer responsiveness are critical and served as key factors in why we won this deal.

In APAC, revenues increased 11% year-over-year to $39.9 million from $35.9 million last year. Among the key deals in the region was a seven-figure firewall deal, firewall win with a large diversified telecommunications company which required increased security for its virtualized multilayer network. The unmatched performance and carrier class network security features we delivered during testing enabled us to beat out the incumbent, Palo Alto Networks, as well as CheckPoint and F5 Networks for this deal.

Turning to Slide 7 and the revenue breakdown by product and services, product revenues increased 32% year-over-year to $76.8 million, driven by larger deals and sales of new products, especially in the enterprise. We saw continued adoption of our recently introduced FortiGate-3700D and FortiGate-1500D high-performance next-generation data center security appliances. The FortiGate-3700D and 1500D utilize our newest FortiASIC network processor 6, or NP6, and lower both capital and operational costs while providing the fastest speed and lowest latency available in their respective categories. Ken will provide more color on these products and specific customer wins in a few minutes.

Services and other revenue grew to $92.2 million, or 18% year-over-year. The increase was primarily due to consistent growth in our FortiGuard subscription offerings and FortiCare support, both offerings generating strong recurring revenue streams as well as growth in our professional services revenue from large enterprise customers. And annualized support and subscription renewal rates continue to be in the mid-70 percentage range. As a reminder, our renewal rates are in some ways understated because renewals are tied to the specific appliance. So when a customer upgrades their equipment by replacing old appliances with new appliances, the associated purchase support will count as a new deal and not a renewal.

With respect to headcount, shown on Slide 8, we ended the first quarter with 2,389 employees, a modest increase over Q4. Our plan is to continue to hire for expected growth, with a focus on expanding sales capacity. Turning to non-GAAP expenses and profitability, during the first quarter, consolidated non-GAAP gross profit margins were 71.1%, at the high end of our guided range. Non-GAAP product gross margins were 58.9%, an increase from last quarter due to the greater mix of high-end products. Non-GAAP services and other gross margins increased slightly to 81.3% from 80.5% during the same period last year. Total non-GAAP operating expenses were $93.9 million during the first quarter, resulting in non-GAAP operating income of $26.3 million, or 16% of total revenue, above our guided range of 12%.

Non-GAAP net income for the first quarter was $18.2 million or $0.11 per share, based on 168 million diluted shares outstanding and above our guided range of approximately $0.08 per share. The non-GAAP tax rate for the first quarter was approximately 33%. And GAAP net income for the first quarter totaled $8.4 million or $0.05 per share compared to $12.2 million or $0.07 per share in the prior year period. Our reconciliation of non-GAAP and GAAP financials can be seen on Slides 15 and 16.

Now, turning to the balance sheet on Slide 10, we ended Q1 with $888 million in cash, cash equivalents and short and long-term investments, up from $843 million at the end of Q4. Looking at Slide 11, the increase was primarily driven the $61 million in cash generated from operations. This was our 33rd consecutive quarter of generating cash from operations. Free cash flow was $50 million in the first quarter, up $13 million or 36% year-over-year. This includes $20 million that Palo Alto Networks paid Fortinet in a covenant not to sue and release agreement. Inventory turns for Q1 were 2.4, above our goal to manage inventory turns at 2 or better on an annualized basis. Our deferred revenue balance increased to $451 million, up $75 million year-over-year and $19 million sequentially. The sequential increase was primarily due to consistent renewals and services attached to new product sales. We continue to build an impressive deferred revenue stream, reflecting customer adoption of our suite FortiGuard security services, which generate recurring subscription revenue.

Finally, as I mentioned earlier, during the first quarter the company repurchased $7.5 million or approximately 335,000 common shares. As of the end of March, we repurchased approximately 2.5 million shares or $46.5 million under the $200 million stock repurchase program that we announced in early December of 2013. $153.5 million remains available as of March 31, 2014.

I will discuss our guidance in a bit, but first, let me turn the call over to Ken who will provide more color on the overall market, new product introductions and our competitive advantage.

Ken Xie - Co-Founder, Chairman and Chief Executive Officer

Thank you, Drew. Fortinet’s strong execution during the first quarter helped us significantly overachieve our finance goal and the growth target. In addition to continue to deliver the innovation, we believe that our result and the last two quarters of our accelerated growth show that the investments we have been making are paying off nicely. So anyone who knows Fortinet knows our technology roots are deep. Our mission is to deliver the most innovative, highest performing network security platform to secure and simplify IT infrastructure. So, we believe our product and technology focus is key for long-term success and we are continuing to deliver on this everyday.

As Drew mentioned, in Q1 we were pleased to see the high level of customer enthusiasm for the adoption of our new FortiGate-3700D and FortiGate-1500D security appliance, both products were introduced later last year. And they utilized Fortinet’s latest FortiASIC-NP6 processor could deliver significantly higher firewall performance, low power consumption and far better price performance than comparable product on the market. Additionally, the FortiGate-3700D is the first security product to include FortiGate’s Ethernet port interface, which is key in integrating high-speed next generation enterprise on the data center networks. This put Fortinet under the forefront of innovation and widened our competitive advantage considerably. Results are what matters and the customer adoption of the new FortiGate-3700D and 1500D appliances has been impressive. During the first quarter, we closed several large highly competitive enterprise data center deals based on our ability to provide the very best performance, lowest latency, stability and the total cost of ownership.

Drew mentioned a FortiGate-1500D deal we won over a Europe government agency. So we also won a number of impressive deals based on our FortiGate-3700D enterprise data center security appliance. So, I feel including a seven-figure win over Juniper, CheckPoint, and F5 with one of the world’s largest internet companies secure several data centers in Asia as a part of the next generation network build-out. We also won a $0.5 million passed deal with a well-known European digital media and music stream company that needed for high-speed security for multiple data centers to support high bandwidth traffic and high volume users. So we beat Juniper here. And finally, as Drew mentioned previously, a large enterprise data center win against CheckPoint with one of the biggest software companies in the world to protect their bandwidth intensive content delivery network.

During the later part of first quarter, we also began the shipping of FortiSandbox advanced persistent threat appliance. While still new to the market, customer and partner interest has been high and as the product has proven itself in the real world test. NSS Labs, one of the industry’s most well-respected testing organization recently conducted an industry-first comparative test of APT products. Fortinet’s FortiSandbox-3000D was among the few to receive a recommended rating ranked among the highest in security effectiveness and in delivering the best total cost of ownership. So we beat (indiscernible) and other competitors in this test.

There is a lot of marketing noise in the security space, which can make it harder to decipher the best product from the one with the most hype. For this reason, third-party testing and industry certifications are key and sometimes our customers tell us they are truly valuable in their decision-making processes. So, to help customers making clear judgment and purchasing decision, one could argue the security industry should have what is akin to FDA approval in the healthcare context, a regular system and a testing process to certify products can actually do what the vendor claim they can do. Security is a critical technology and that if it is failed to perform as marketed, the outcome could be serious. So, unbiased third-party tests like NSS are the closest thing to this as it is the only time the public can see the result of the computing products testing against each other under the real world conditions.

What we have setup in our marketing activities in whole Fortinet is a technology focused company and our products sell, because of technology superiority, not because of the hype. So, this is proven by the fact that Fortinet has most third-party certifications than any other security vendors. You can see all this on Slide 12. When we get into a deal, our products are tested alongside competitors. We most often win and our customers recommend our product to others everyday, which is something we are very proud of.

During the quarter, we also increased our offering on apps and web services with the addition of our flagship FortiGate virtualized security appliance. Our FortiManager-VM and FortiAnalyzer-VM are also already available on AWS enabling customers to deploy security management and reporting to FortiGate and FortiGate-VM products running and of age in the internal networks and at the remote office within the coded center are deployed in the cloud.

Finally, on the new product front, as Drew mentioned, we are also seeing traction in the sales of our complementary FortiGate products, like our FortiWeb application firewall, the FortiMail e-mail security appliance and FortiAP secure access wireless appliance. While still minority of our total revenue today these products expand our growth opportunity and total addressable market, which IDC forecasts to be $13 billion in 2017. As I look ahead, I am confident about the future. We plan to continue to invest in responsibly and given our market opportunity as we remain optimistic about our ability to maintain momentum in 2014 driven by a number of factors that bode well with Fortinet.

First, the growing APT opportunity and the requirement of our extended next generation firewall deeper and broader to including deep flow anti-malware and integrate sandbox into combat the most sophisticated threat. Our FortiSandbox appliance has been sure to be technically superior in the effectiveness and far more competitive total cost ownership to most APT products and our market-leading FortiGate next-gen firewall appliance has receiving numerous specification and award and secured the majority of a global Fortune 500 company today. Second, the enterprise and service providers are beginning to build out their next-generation data center networks, which will leverage the 40-gigabit and 100-gigabit interface to deliver terabyte of performance. Fortinet is the only security vendor that can deliver upon this network and security performance requirement today.

And finally, the cloud and mobile security opportunity in front of us, which required the need to protect and access internet ability device and applications in wired, wireless and a virtual environment. As you can see on Slide 13, Fortinet offer virtualized product to support all major VM platforms, including VMware, Citrix, Amazon, Microsoft and RedHat.

Now, let me turn the call back to Drew who will discuss our forward finance guidance.

Drew Del Matto - Chief Financial Officer

Thank you, Ken. I want to finish with our financial outlook for the second quarter, as well as provide some directional guidance for the full year 2014. Although we may choose to revisit how we give guidance in the future, at this time we are comfortable with the approach we are taking. Before reviewing guidance, however, let me remind you that our guidance consists of forward-looking statements, and please keep in mind Michelle’s earlier comments regarding such statements.

Looking back at our results over the last few quarters, it’s clear that Fortinet has been executing well. The network security market is healthy and dynamic. Increased high-profile cyber attacks keep network security at the top of customers’ minds along with the compelling technology market drivers Ken just mentioned, such as advanced persistent threats, next-generation high-performance networks and cloud and virtualized environments.

Fortinet’s broad platform of innovative and certified network security products and our clear performance advantage position us well to continue to grow and gain share. As I stated earlier, for this reason, we have been investing responsibly and deliberately for growth, and these investments are paying off. We intend to continue this strategy with an ongoing focus on building self-capacity and self-enablement along with increased marketing and a continued commitment to technology innovation. We believe it is the right thing for our business and that it will yield returns over the long term.

With that as background, let me now provide specific guidance metrics for the second quarter of 2014, which can be seen on Slide 14. We expect billings to be in the range of $185 million to $190 million, up approximately 17% year-over-year at the midpoint. Total revenues is expected to be in the range of $169 million to $172 million, up approximately 16% year-over-year at the midpoint.

Non-GAAP gross margin is expected to be approximately 70% to 71%. Non-GAAP operating margin is expected to be approximately 13% to 14%, reflecting the continued growth investments I just mentioned. And finally, we expect non-GAAP earnings per share to be approximately $0.10 per share based on an expected diluted share account in the range of 168 million to 170 million shares.

In terms of 2014, we have seen the continuation of improvements in the overall network security spending environment that began in Q4. This combined with the return on investments that we’re beginning to see and will continue to make in sales and marketing, our ongoing focus on execution and technology and performance leadership give us confidence in a slightly more positive view on top line growth. Though we are currently maintaining our full year directional guidance range of billings growth of at least two times that of the network security market, we feel confident that we can perform at the high end of the range or better.

Analysts currently forecast the market growth rate as 6% to 7%, which would take us up to the 14% growth or higher range. We believe this represents a reasonable growth outlook. It is still early in the year. As we gain more visibility on the full year, we will make adjustments, if appropriate, at the right time. In regards to the bottom line, we still expect to deliver annual operating margins of approximately 17%, plus or minus a point due to fluctuations in the business, investment activities and top line results.

In closing, I would like to take this opportunity to express my enthusiasm for the future at Fortinet and to thank Fortinet employees, partners, customers and shareholders for their continued confidence and support. With that, Ken, Michelle and I will now take your questions. Operator, can you please start the Q&A?

Question-and-Answer Session

Operator

(Operator Instructions) So we will take our first question from Brent J. Thill from UBS. One moment, Brent, while we open your line. Your line is open.

Brent J. Thill - UBS

Great. Good afternoon. Congrats on a nice quarter. I guess, Andrew, just when you talked about the growth rate and deals more than $500,000, that’s a pretty drastic change considering a seasonally softer Q1. Can you maybe just give us a little more color on what you’re seeing? I know you mentioned telco was strong, but can you also mention other segments that helped drive that and how sustainable you think that is as you look at your pipeline going into Q2 on the large deal front?

Drew Del Matto

Yes. Thanks, Brent. I would say that there is quite honestly I don’t have a lot more color to add. I think we feel very good about what we saw on the enterprise. That’s where we see the bulk of the big, the larger deals. I think we mentioned last quarter that people were asking how would we see, how would get credibility and traction in the enterprise, so I think we pointed out that we would hopefully see a positive trend and the larger deal size growing, and I think that’s what we saw. As far as the funnel goes looking forward that would tend to be what we see right now as well, it’s early in the quarter, and one of the things we’re seeing is just that simply the deal profile changes in a way such that I think it gets a little harder to predict exactly what’s going to happen in a given quarter. You end up with kind of a bigger funnel, but a little more hit-miss on the deals as they grow larger in size which would be typical of any more enterprise-focused company.

Ken Xie

Yes, Brent. Also, remember one year ago, we mentioned we started building more dedicated teams for the enterprise and vertical space. I think that’s the benefit or result of the effort we put in there. Now because this dedicated team, they tend to focus on bigger deals, and that’s probably what ends up as a more larger deal we are closing right now.

Brent J. Thill - UBS

Okay, thank you.

Drew Del Matto

Yes. The other thing I would point out is we sold very good traction on the 3700D and the 1500D, which again, are enterprise and 3700D especially in data center.

Brent J. Thill - UBS

Terrific. Thanks.

Operator

Okay, thank you. And our next question comes from Keith Weiss from Morgan Stanley.

Melissa Gorham - Morgan Stanley

Hi. This is Melissa Gorham. I am calling in for Keith. Thanks for taking my question and nice quarter. I just have a question for Andrew. On the service provider business, you saw a really nice rebound in Q1. Moving forward into 2014, should we assume this level of growth is going to sustain or is there any sort of one-time impacts in there that contributed to the strong growth in Q1?

Drew Del Matto

Thanks, Melissa. First of all, so we are not really giving guidance beyond what we just said, kind of the 2x north of the benchmarks we shared, but I wouldn’t expect a big change. I think there’s nothing we see specifically that would change it one way or the other.

Michelle Spolver

Yes. And actually, Melissa, this is Michelle. So let me actually add on that, too. If you remember back in Q1 of 2013, service provider was one of the areas that was weak for us and across for many companies during that time, so that’s why you’d see a bigger impact year-over-year in the service provider business. We talked about the end of Q4, seeing a bit of a rebound and going to more normalized spending patterns, we saw continuation of that in Q1.

Ken Xie

Also we see a lot of service providers they are testing the 4G LTE, especially the Tier 1. They accelerated the testing. And Tier 2, Tier 3 are starting to have some deployment, but not in Tier 1 yet. So that is a service provider that you may see get probably more normal compared to one year ago, but you still will not see, like the big acceleration of the 4G LTE is not significant yet.

Melissa Gorham - Morgan Stanley

Okay, great. And then just one follow-up on investments for 2014, and specifically related to sales hiring. Can you maybe just provide some more color in terms of where you are in terms of sales capacity and how we should thinking maybe about head count ramping throughout the remainder of the year? I know that the head count ads have been growing pretty nicely, but it did decelerate a bit in Q1, so just wondering how to think about it for the remainder of 2014?

Drew Del Matto

Well, yes. I think we have given you one, from a modeling perspective, I think we’ve given you kind of how we’re thinking about the broader top line growth with 2x the benchmark or better and then I believe we gave some operating margin guidance as well. So we’re trying to live within that framework for now. In terms of the investments, what we’re seeing as we add head count, they tend to pay off two or three quarters later. We’ve seen that consistently for the last couple of quarters. And so we’re trying to basically continue to build that momentum. We see a lot of opportunity, and we literally saw a benchmark, or, excuse me, a comment from Gartner where they forecast 75% of all enterprises will buy network security from a vendor other than their network infrastructure provider. And so, we see a variety of opportunities like that in the enterprise and just in specific geographic areas and we’re targeting those areas for investments, and we hope that they pay off six to nine months later.

Melissa Gorham - Morgan Stanley

Okay, that makes sense. Thank you very much.

Drew Del Matto

You are welcome.

Operator

Thank you. And our next question comes from Sterling Auty from JPMorgan. Please go ahead.

Sterling Auty - JPMorgan

Yes, thanks. Hi, guys. Wanted to drill into looking at the mix of products, the mid-range and the high-end, so the high-end was a number of percentage points higher. Mid-range, I think, was down year-over-year. Is that a reflection of where you’re allocating those investments in sales and marketing? Is it representative of what’s happening in the marketplace or something else?

Ken Xie

I think the two new products, the 1500D and 3700D helping accelerate some of the high-end and then – because they’re using the new NP6, and then the industry will start building to the other high-end also the middle-range products. I think that probably will be later this year, helping on the middle-range and the other high-end product. Also, it’s kind of some contribution from the dedicated team. When the deals got bigger, they do, including the high-end box, but also a lot of time they also include a lot of smaller boxes, especially like the retail space, and some others like, they call it the CPE space or service provider space, so they’re including both ends. So that’s where the high-end box and also the small CPE box also kind of has a good increase. But once we have the NP6 starting out in the middle-range, we believe that will also help in grow the middle range.

Sterling Auty - JPMorgan

That makes sense.

Michelle Spolver

Yes, Sterling, actually, if I can add to that, too, which Drew talked about in this commentary, that in Q1 in particular, we had a few service provider deals where they were CPE-based deployments and included a lot of low-end boxes which therefore made that number, made the entry-level category a bit higher than it would have been otherwise. And to answer the first part of the question, I don’t know if it’s a direct reflection of where our investments are. We have been focusing our investments, especially on the marketing side, in the enterprise, and so I think that’s showing the payoff there with that category getting larger.

Sterling Auty - JPMorgan

Okay. And then one follow-up question. I get asked often – you mentioned the virtual appliances that are available in the AWS marketplace as an example. One of the questions that I often get is, are you allowing customers to utilize their existing licenses on those virtual appliances, meaning moving them over, similar to like what a Barracuda might do, and really what people are trying to get to is, when you think about that virtual opportunity, how incremental do you think that market and growth will be versus just kind of transitioning stuff from on premise to the cloud and not really generating much incremental revenue?

Ken Xie

I think first the virtual market, especially now with security is still relatively very small. So the common numbers early by 2017, less than 10% of network security will be on a virtualized platform. But with that said, also virtualized in some data centers, if they already have some existing servers, they may leverage the server’s computing power to deploy the virtualized appliance compared to you putting in the dedicated power. Dedicate power is still much higher performance like, way faster, like 10x faster than the virtualized because all the acceleration we have on the FortiASIC or other things. I think that’s, we see that space is complementary to some of the real appliance, and especially some data centers, they have actual computing power, they may using some virtualized, and also some other sort of application, like the one we work closely with, Amazon, they also expanded quickly in their current resolution, because they have a huge server farm they may leverage that like a platform to do some virtualization.

Sterling Auty - JPMorgan

Great, thank you.

Operator

Thank you. And we will take our next question from Jonathan Ho from William Blair. Jonathan, please go ahead.

Jonathan Ho - William Blair

Congratulations on the strong quarter. I just wanted to start out with, from a geographic perspective, if we could get a little bit more detail on your thoughts around APAC. I know you guys said that it was a tough comparison, but just wanted to see where you see an opportunity to essentially improve those results throughout the course of the year and maybe some color in terms of actions that you are taking?

Ken Xie

I think we do see potential APAC as a high growth area. We are just trying accelerate some of the investments, especially the sales capacity in APAC, which we kind of grow relatively slow compared with the top line in the last few quarters. But also, like Drew said, there’s a tough comparison compared to one year ago, and but we do see in the other major countries there, it’s a pretty nice growth.

Drew Del Matto

Yes, I would echo Ken’s sentiment. It’s something to point out because when we look at our model and how we’re ramping we could see actually that we had – we made a couple organizational changes there over the last couple of quarters, one. And then I think the hiring kind of flattened out mid-last year. And we’re hoping – and if we look at the other geos we were investing more, relatively more, and we saw relative more pay off in the last couple of quarters. And so they actually illustrate the opportunity to grow.

Ken Xie

Yes, the other thing also, in APAC we’re also starting more focus on some dedicated verticals and also some enterprise carriers. So you can see that the bigger deals we win I mentioned in earning calls conference the APAC, which is like a seven-digit deal has not happened a lot in the past. So we started to see more opportunities for the bigger deals, right now in APAC.

Drew Del Matto

Yes, that’s right. And they also had a pretty strong Q1 last year as well. I think it grew 25% in Q1 2013 versus the prior-year.

Jonathan Ho - William Blair

Got it. And just in terms of the non-FortiGate products, you guys highlighted that, that’s sort of an increasing growth opportunity for you guys. You’re seeing sort of more interest in it. Is this one of the contributors for larger deals? And should we be looking at this as maybe a potential second set of drivers? Is it more sort of for 2014, more for 2015? And just how, can you give us maybe a sense of how fast these non-FortiGate products are growing year-over-year? Even if they’re not large today just some additional color would definitely be helpful. Thank you.

Ken Xie

I think we are still – the number is still relatively small. That’s why we don’t quite break it out. But I can say we have a very good technology we call the non-FortiGate or FortiGate complementary like the FortiWeb, the FortiMail, FortiSandbox, the FortiDDoS. So all this product you can see from all the testing, all the certification, we are ahead of our competitors in that space, which they only do some dedicated. I mean they only sell in that particular narrow-focus space, compared to we have much broader solutions. The other thing really we call the FortiGate complementary because these products are also working well with FortiGate. So once the FortiGate is starting to deploy sometimes the Web server, the e-mail server, DDos for the data center, the Sandbox and also can working with firewall. So that’s where we also see some opportunity to upsell and to broaden this market space. I think it’s – maybe, Drew, you want to add some detailed numbers?

Drew Del Matto

Yes, no, probably not get into numbers, but I mean, I think the way you should think about it is it’s just something that could be included with the FortiGate broad platform deals, where we have broader platform deals. Quite honestly, they’re not huge numbers yet, but they are growing year-over-year very nicely. So I think it – I mean, in terms of big, large numbers, you’re probably looking more over the long term than – look it’ll help in 2014, but it’ll help more longer term.

Jonathan Ho - William Blair

Great, thank you.

Ken Xie

And then also, most importantly, all the internally developed leverage our firewall technology and also more broad IP patents.

Operator

Okay, thank you. And we will take our next question from Gray Powell from Wells Fargo.

Gray Powell - Wells Fargo

Great, thanks a lot. Just had a couple questions, if I can. So you highlighted on the call that Fortinet scored very well on the recent NSS Labs test for advanced malware detection. How has that impacted new customer interest in your new Sandbox appliance item? And I know it’s only been a few weeks since the test came out. And then when should we think about that product gaining traction and becoming material to billings?

Ken Xie

I think first, the impact on the particular product, FortiSandbox, is relatively small because we only announced like, probably like a few weeks, at the end of the quarter. But we’ve proven we have very strong technology, especially now the Sandbox, but also the FortiGuard, the global service and security intelligence service. So that’s part of the result because we have very broad and very deep security intelligence supporting service globally. And that’s also not only benefiting the Sandbox, but also the FortiGate, the FortiDDoS, the FortiWeb, and also the other products we have. The other part really we do see the APT key starting to become kind of a, quite a topic for larger enterprise and larger, like, Internet service providers. So we see that’s one of the three driving forces I mentioned as not only the APT, but also the upgrade for the 40-gig to 100-gig and also the cloud/mobile solutions. It’s one of the three driving force to driving the market today. So we’re positioned well, and also we’ve been involved in the technology for many, many years and we can quickly respond to what the market needs.

And then also, the advantage we have, also we can also gradually start including all this technology into the chip, which can accelerate the performance like 10x compared to some software solutions. And software, especially software when they have multiple functions enabled in the PC or server kind of software-based platform compared with we have both the best CPU and also the best ASIC, which are doing quite well with this multi-function device. That’s when we see the benefit of the platform to helping the solution of customers.

Drew Del Matto

Yes. And then, Gray, it’s true. And I would say in general the recent test results that we published from NSS did generate some buzz. I think quite a lot of buzz within the network security community for sure. But also in general, we drove some campaigns out there to kind of get people NSS-aware and I think buyers are starting to become more conscious about those results. We had some inbound, let’s say, pull. We’re actually, if you think of sales being more push – salespeople knocking on doors or inside sales dialing up or even campaign driven; we’ve actually had some pull, in other words, customers referencing results and saying hey, I was researching the space. We’re in a network security upgrade mode and we’re looking to put in new network security and I saw the results and I saw that you were recommended relative to another thing we were looking at that wasn’t, and/or something we might have been looking at also that was. And we’d like to talk to you and hear more about your products and offerings. So that’s what we’re looking for and hopefully we can get more awareness out there through the testing and also through campaigns.

Ken Xie

Yes. I think I mentioned it in my script, actually. We see the testing certifications are very important because most of our customers, especially enterprise customers, they don’t have the capability or don’t have the environment to do all this testing, so that’s where throughout these few years we’ve spent a tremendous effort to make sure we’re the best in the third-party evaluation testing and focus a lot on the testing. So that’s where in the slides, you can see we have more certification testing than any other vendor in the space. So that’s just one of the results of our effort to focus on the testing technology we have.

Drew Del Matto

And that’s a solid message for us to utilize in our campaigns.

Gray Powell - Wells Fargo

Got it, okay. And then you kind of touched on my next question. I just was kind of thinking of those test results as almost free marketing, and you said it’s kind of helping you get your foot in the door with customers. In terms of the customers that are looking to test your FortiSandbox solution, is there a particular vertical where you feel like you’re having the most inbound calls? You kind of said enterprise broadly. Is it like technology or healthcare or financial services, just any particular customer set that’s looking at you?

Michelle Spolver

I think at this point it’s too – the products have only been available for a couple of weeks so I think right now it’s fair to say it’s across the enterprise, not – we can’t get more specific in terms of exactly which verticals are requesting them more.

Gray Powell - Wells Fargo

Got it. Okay, fair enough. Thank you very much.

Ken Xie

Thank you.

Operator

Thank you. And our next question comes from Daniel Ives from FBR. Please go ahead, Daniel.

Daniel Ives - FBR

Thanks. Great quarter. So, Ken, what’s sort of your view, I mean, obviously a lot of company-specific success, execution products but from a secular perspective, I mean, maybe just talk about security, where you’re seeing it today in terms of budgets, deal flow, overall in terms of interest maybe relative to where we’ve seen over the last year or two. I mean, obviously you guys are benefiting kind of – I’m just be interested from a secular perspective how you’re viewing security relative to what we’ve seen over the last few years?

Ken Xie

I think probably like I mentioned the infrastructure upgrade that’s happened every like four or five years. And we starting to see the cycle started again compared to like 2009, 2010, which was after the (indiscernible). Now we see the data center, big enterprise starting to see the 40-gig to the 100-gig. So that’s what’s helping drive the – because network security is a part of infrastructure. If you have a faster like a switch and all those kind of things in enterprise data center, you do need the faster secure gateway. So that’s why we see the high-speed interface like the 40-gig or the 100-gig is very critical, very important. So you need to have a solution in order to participate in this kind of RFP.

The other part I have to say in the last like 6 to 12 months there are some – I think some kind of hype about APT and also a lot of news that also drive a lot of interest sometime, not only in IT but also go to the company and management, even the board level, to see the important of security. We also try to leverage that one. The other part is especially we try to build some dedicated team to target some big enterprise and also some of the we call distributed enterprise, more like retail kind of thing. And the other part I mentioned in the last few quarters, probably we starting see more testing going on, but not quite a result and a lot of business yet. It’s really the 4G LTE audit (indiscernible) the traditional server client called the mobile space, especially a lot of mobile device. They have to have a lot of important data to secure, and the cloud also causing a lot of important applications, a lot of data there. So that’s why see the interest from service providers for the 4G LTE we see kind of accelerated testing and evaluation in the space. But it’s still more in early stage and not see a lot of result yet. But we do believe this will be also huge growth opportunity but it’s still in very, very early stage.

Daniel Ives - FBR

And just as a follow up, do you sense that Fortinet is getting invited more in terms of like seven-figure deals from these larger deals and maybe before you should have built-out the product there, and maybe some of the channel that you were not getting invited in terms from these multi-million dollar deals?

Ken Xie

We do. One thing it’s because we see that especially once we have the new technology, NP6. Now we have a much faster and a lot of times the only solution on the market is that high-speed and the low-latency solution. So we started to get more invited. We also started increasing some sales capacity, because we feel that we’re still much more efficient than some of the high-growth network security companies. You can look at the percentage for every dollar sales we spend and compare to some of the other high growth network security companies we are still much more efficient. So that’s where we changed the strategy almost one years ago, try to invest more into the sales and marketing capacity. We can see some good results come out in the last two quarters. I think that we believe that there’s a huge opportunity in the market, and gaining market share is still kind of more valuable. So we’re contending to invest in this area.

Daniel Ives - FBR

Got it. Okay, thanks.

Ken Xie

Thank you.

Operator

Thank you. Our next question comes from Aaron Schwartz from Jefferies. Aaron, please go ahead.

Aaron Schwartz - Jefferies

Hi, good afternoon. Thank you. When I look at the results here, you had a material upside on the product revenue side, and it seemed like a little bit less so on the deferred side. So the product revenue really provided the bulk of the billing side performance. Is that a function of the strong telco performance we talked about here in the quarter, and that your telco customers maybe tend to buy firewall-only solutions more so than your enterprise customers? Could you walk through the dynamic there?

Drew Del Matto

Aaron, it’s true. Maybe I could clarify the question a bit. Are you asking about the strength of the product revenue?

Aaron Schwartz - Jefferies

I am just asking what the – yes, in a degree. But I would have expected deferred just to see similar strength and it – all the numbers were obviously strong here, it seemed like the outperformance was really on a product side. So is that just a function of the mix more towards service provider in the large deals that you talked to where you tend to see just more firewall only deals there and just a lower attach of the other services?

Ken Xie

So I think clearly, the product is the leading indicator because if you’ve got a product coming first, and then certainly able to service during the deployment. One service sometimes they call that bundled service. Service usually come after the product. So we do see – happy to see the product. Especially we mentioned a new product, we see some good acceleration, the 1500D and 3700D we see it quite nicely ramp up.

Aaron Schwartz - Jefferies

Right. I guess I thought with the bundle if you’d still book the deferred at the time of shipment. And so I’m just wondering on the new products you called out if those are more likely firewall-only sales?

Ken Xie

Probably not, I think it’s a lot of firewall we later converted into – add additional service. Like we said, we probably averaged about 80% of product they deploy will be on the firewall function, the firewall only probably only account on about 20% or less.

Aaron Schwartz - Jefferies

Okay. Maybe just a quick other question, probably for Drew here, but on the $20 million you called out on the cash flow, was that purely a cash flow event or was anything taken through the income statement? Thanks.

Drew Del Matto

You are talking on the pan?

Aaron Schwartz - Jefferies

Yes.

Drew Del Matto

No. We are amortizing that over six years.

Aaron Schwartz - Jefferies

Okay, so is that straight line so we can just do the math to...

Drew Del Matto

Yes, and it started in February, so you wouldn’t get a full quarter in Q1. I think it was – yes, February.

Aaron Schwartz - Jefferies

Okay. And is that on the product or the services line?

Drew Del Matto

It’s actually contra expense.

Aaron Schwartz - Jefferies

Oh, it’s a contra expense?

Drew Del Matto

Yes.

Aaron Schwartz - Jefferies

Okay, perfect. Thank you.

Operator

Okay, thank you. And our next question comes from David Kaplan from Barclays. David, please go ahead.

David Kaplan - Barclays

Hi, evening everybody. Most of the questions have already been asked, but if we can touch a little bit, you guys focused a lot on the fact that the large deals are coming from upgrade cycles on the infrastructure. Do you think we are still at the beginning of that cycle or have we worked our way through it to some extent? That’s the first question. And then the second question, you guys also mentioned specifically your web application firewalls. So traditionally, we have talked about comparing in-line security for enterprise, and are you seeing the same kind of preference from customers in the data centers or, in data centers also, for an in-line sales single vendor providing a number of solutions? Or is there a little bit more flexibility in those data centers?

Ken Xie

Yes, this kind – I think probably if you see the new infrastructure upgrade, especially the 40-gig to 100-gig is still in very, very early stage, so it’s, because it’s just in the beginning of the fresh upgrade, you can also see some of the numbers from some other networking solutions vendors, but since ramped up nicely there. As you mentioned, talking about whether the prevention or detection, we more favored the prevention deployment is, whether the FortiGate or some other, like a DDoS or other product, if you let us know when and we’re already helping the IT guy to really combat all the threats there, the detection mode is whether, like ten years ago, the intrusion detection compared to intrusion prevention. Today it’s more like a malware APT. We feel it’s more difficult for the IT guy to really quickly react and it sometimes becomes a big burden for them like the big news, the end of last year in the retail when this is really – they detect like thousands of intrusions every day and it’s very difficult to do anything about it. So that’s where the big solution you have would be the in line prevention solution which can automatically act, react to all these kinds of attack.

And at the same time if there is some actual project that we also maybe sometimes could be multiple layer solutions, especially on the malware side and also what can a service provider carrier. We see some carriers starting offer what they call the clean pipe solution, which is also additional protection come from the infrastructure is also another benefit instead of a low out of burden to some enterprise and to the customer. So that’s where we see the combination with the infrastructure carrier service provider and also we call the security service provider, (indiscernible) and also enterprise themselves, this multiple layer to protect all their tech from malware side, especially the in line devices is really the one can really provide a value compared to just reporting all kind of a detection, which can make a very good noise, very good hype but it’s really going to solve their problem.

David Kaplan - Barclays

Great, thanks. Okay, thanks very much.

Operator

Thank you, sir. And our next question comes from Jayson Nolan from Robert Baird. Please go ahead.

Jayson Nolan - Robert Baird

Great, thank you. A couple clarifications first, 3700D and the 1500D are classified as high and low end or mid range?

Ken Xie

It’s a high end.

Jayson Nolan - Robert Baird

Because of the NP6?

Ken Xie

Because I think because of what we call it a parcel because the category (indiscernible) than like one or two-year. Two-year and above is at the high end recommend. And then the one-year tend to be middle range then the next part to be the low end.

Jayson Nolan - Robert Baird

And the 5000 series has yet to be released with the NP6, is that right?

Ken Xie

Yes. Yes.

Jayson Nolan - Robert Baird

And that would be a high-end chassis also?

Ken Xie

Yes, that’s right.

Michelle Spolver

The 5000 is a high-end chassis. The other two are appliances.

Jayson Nolan - Robert Baird

Right, okay. My question, probably for Drew, if you could talk a little bit about sales and marketing spend, how those dollars are being deployed sales versus marketing? And how you’re measuring the performance of that in the field?

Drew Del Matto

Right. So I assume you are talking about going forward, Jayson?

Jayson Nolan - Robert Baird

That’s right.

Drew Del Matto

Yes. I think we are still investing in marketing. We still need – and I think of marketing as being more kind of sales enablement and it goes back to very consistent method with what we were saying last quarter about it’s time – we are driving campaigns. And if you take the NSS test results as an example, you drive campaigns off that. You serve people ads. Hopefully they’re going to click and you’ll lead billings, you’ll lead, excuse me, generate leads off of that, that the sales people then get developed in the field or inside sales and it gets hopefully turned into a billing at some point. And so that’s very much where we’re focused right now. That’s the type of marketing activity we’re focused on. So the other part of sales enablement would be process orientation so as we get to current and new people on board, we’re very much focused on them measuring their funnel and measuring their progress with the funnel through to closure. And we’ve been doing that for a while I would just say I think the discipline and the hygiene around that’s getting better. There’s still a bit of investment just kind of getting people trained to do it consistently so that we can predict the business with more clarity, kind of have better insight into the business by deal size and just overall what we think’s going to close in a given period.

Jayson Nolan - Robert Baird

Okay, great.

Drew Del Matto

Yes, okay. Other than that I’d say sales capacity. We’re also, we see, we believe there’s opportunity for sales capacity.

Jayson Nolan - Robert Baird

Headcount.

Drew Del Matto

Yes, headcount. We need more feet on the street and yes, just make sure we have the right coverage model and we’re covering off all the accounts we can. We see a lot of opportunity.

Ken Xie

Yes, there is quite some vertical space. We don’t have enough coverage yet. So we will continue to invest in that vertical space.

Jayson Nolan - Robert Baird

Thanks, guys.

Operator

Okay, thank you. And our next question comes from Shaul Eyal from Oppenheimer. Please go ahead.

Shaul Eyal - Oppenheimer

Thank you. Hi, good afternoon. Great quarter, guys. Two quick questions on my end; I want to go back to some of the commentary you made on your performance specifically in Japan. Drew, Ken, what’s behind it? Are you been displacing some of your bigger competitors within Japan specifically?

Ken Xie

I think we changed a little bit strategy in Japan because we in like in the last few quarters we started building some dedicated teams to target some big service provider carrier enterprise. So we see that part starting to pay off right now. And on other side is also we have pretty strong local team, which also kind of do a lot of supporting locally. And also we have a lot of long-term partner starting to see the value, the benefit we deliver on the product technology. So they are starting to helping on the growth.

Shaul Eyal - Oppenheimer

Got it. Got it. And as you guys continue to increase your head count U.S., EMEA, what companies specifically are you hiring from? Is it diverse? Is there any major difference between the R&D hiring and the service marketing hiring in terms of the company that you’re able to draw talent from?

Drew Del Matto

Look, I think – I don’t think it would be to anyone’s benefit to mention specific companies that we’re targeting for hire. But I would just say look, we’re looking for experienced people who are capable of selling our product. I think we have a very compelling product line and a very compelling message and a very compelling market. And we’re just looking for people who are very motivated and want to win in the space and make decent money along the way.

Shaul Eyal - Oppenheimer

Good job. Thank you.

Operator

Thank you, sir. And our next question comes from Walter Pritchard from Citi. Please go ahead.

Jim Fish - Citi

Hi, guys. This is actually Jim Fish on for Walter. So you guys have kind of talked about that this year is mainly an investment year for sales and marketing. As you look out beyond fiscal year 2014, how are you thinking about margins and your desire to drive some margin expansion versus say investing back in the business?

Drew Del Matto

Yes. Jim, we are not giving long-term guidance beyond what we’ve mentioned. So for the year, we’re saying we believe we can grow at 2x or better than market, market being 6% to 7% per IDC and Gartner and then within the margin framework we outlined in the call.

Ken Xie

Yes, I think we, like I said in my script we say we invest responsibly and stably. And we are in much, much better position compared to some companies all growth and not profit, as some companies all profit and not growth. So we can kind of nicely go balance or justify our self because of the position we are. We do believe right now the market more values the growth, so that’s where we move towards the gross investment right now.

Drew Del Matto

Yes, I mean, but obviously, we’re going to be smart about what we’re doing. I think it’s really a function of can we continue to see the results we’re seeing, are the investments paying off, can we continue to see the opportunity. But right now, we view ourselves as opportunistic. We believe that we’re probably short on the people we need, the feet on the street and the marketing that we need to grow at the level we believe we can grow at. And so I think as we said in the guidance, as we have more information, we’ll update you more at that time.

Jim Fish - Citi

Okay, great. Thanks. Just one more is about this $20 million from Palo. Why’d you go at it this way as opposed to taking another strategic route besides using this, I guess as well as the typical question of what’s the capital strategy going forward with having almost – just under $1 billion here in cash and equivalents?

Drew Del Matto

So you want me to take – it’s two different questions. I’d be glad to take the last part of it first. So obviously on – in terms of capital strategy, there’s no change from prior quarter. We continue to look to invest in the businesses we just talked about, increasing the sales and marketing investment. We don’t see anything huge M&A-wise, but obviously there could be some sensible inorganic activity at some point. Again nothing – there’s nothing specifically there we would call out or even are targeting at this point in time. In terms of buybacks, I guess that would be the third part of that, we’ll continue the same guidance we talked about last quarter. We’ll be opportunistic and when the share price looks attractive to us and we believe it’s a good investment we’ll be in the market.

Ken Xie

Yes, I can try to answer the first question. I think, first, this is one of the good recognition of Fortinet long-term innovation and also a pioneer in the space and like we started the company 14 years ago and view that the first multi-function device that with platform leverage both the hardware, software and also the service model. And on the other side I think it’s, I myself as more engineer, I think sometimes we – even competition spends some more money like to recognize all the long-term IP, all the innovation we have compared to spend lot on the quarter on the legal fees. That’s maybe a better use of the money. So that’s probably – we feel this is the better way to resolve some of the disagreement.

On the other side we will continue to keeping invest and also keeping innovating. And like I mentioned that the Fortinet, the vision, we want to be the most innovative and the highest performance IT security with our simplified IT solution. So we’ll continue to go through that path. And also like end of Q1 we had like 159 issued patents. We have other, over 100 pending. So we will continue to innovate and also continue to deliver the best that – the products in the space. So I think that that’s just to reflect of the whole company culture, the whole strategy we have long term for the company.

Jim Fish - Citi

Okay. Great color, guys. Thanks.

Drew Del Matto

Thank you.

Operator

Thank you. And our next question comes from Michael Turitz from Raymond James.

James Wesman - Raymond James

Hey, guys. Good afternoon. It’s James Wesman sitting in for Michael. Question for Drew and Ken. You mentioned in the prepared remarks some of the work you’re doing with large resellers in the Americas. Could you give us some more color on what you’re doing with them and was that where some of the big deals came in the quarter?

Michelle Spolver

Actually, I can take it, James. So the type of resellers we’re talking about are for the larger national focused resellers that focus on midrange enterprises we’ll say that they’re not usually going to be the very, very high end service providers of very, very large enterprises. Those are like a FishNet or that type of reseller. So what we’ve done is really expand the partnership we had in place with those type of national resellers. Do a little bit more in the way of programs support, personnel support on that, things like that just to really strengthen and grow the relationship. So it’s not anything significantly different because we have those partnerships in place. I think what we’ve done is putting some more focus and more investment behind those partnerships.

James Wesman - Raymond James

Yes.

Michelle Spolver

I guess the other thing that contribute to the seven figure deals – I don’t believe the ones we have talked about on this call – typically they would be more in the mid-range enterprise space.

James Wesman - Raymond James

Okay, that makes sense. And then I’ve got a higher level question for the company as a whole. Do you have any thoughts of moving from network security into end point? Some or your competitors have acquired in these end-to-end point space so I was wondering how that relates to Fortinet – if you guys have thought about doing that?

Ken Xie

I think – I believe it’s kind of two different markets that need two different approach, and so far you’ll see – I’ve been in this space for more than 20 years. It’s a – we address two different kind of issue and so we still believe focus on network security is a key – it’s a better solution.

Drew Del Matto

Yes. And I would just add that and I have a little bit experience on both sides – just that – this is Drew – that there’s also two different buyers. Very often of both of those products and I think when you think about investing responsibly it’s almost like you need a separate sales force to go sell that. So that’s something that would be a – certainly a headwind when you think about that equation.

James Wesman - Raymond James

Great. Thanks, guys.

Operator

Thank you. And our next question comes from Robert Breza from Sterne. Please go ahead.

Robert Breza - Sterne

Hi, thanks. Just two quick clarification questions. Drew, you talked about headcount and the investments you’re making on sales and marketing side. Should we just expect head count to track more towards the revenue growth rate? And then as clarification maybe – you talked about your large deal pipeline, it was up very significantly. Wanting to compare contrast the large deal pipeline maybe from a year ago or as you think about it going into next quarter. Is it up substantially or just as you think about your guidance I’m sure you’re looking at your pipeline with those large deals. So any color would be great?

Drew Del Matto

Yes. I mean it’s up clearly at some point the headcount growth should scale with the revenue line. I think near term, they may fall out of balance from time to time, and there’s a little bit of – it’s a challenging question because it doesn’t exactly work like that. There’s some quarters you may hire faster or slower, you also may have some turnover for a variety of reasons, so it never quite exactly works out like that, but I think as you build out models you do two things. One you try to build capacity to drive your certain head count growth, so they do try to scale over the longer term, and then you try at some point try to – not that we’re giving long term guidance, I’m just talking theoretically, you know at some point you would try to drive some efficiency in that model as well. So the people are more productive over time.

Michelle Spolver

Yes. And I think on this second part of the question on the large deal was that last year at this time for the year-over-year comparison, in Q2 of 2013 we talked about having fewer large deals than we would have typically seen, so to be fair, obviously our growth was very impressive in terms of large deals, but it’s also coming off of a quarter year-over-year, the prior that was weaker on large deals. And then we can’t give too much color really at all about the large deal we have on track for Q2. We don’t really talk about sort of the pipeline, but I would say take that into account that in Q1 we did have an easier comp year-over-year in Q1 of last year.

Robert Breza - Sterne

Thanks. Nice quarter.

Michelle Spolver

Yes.

Drew Del Matto

Thank you.

Operator

Thank you. And our next question comes from Sanjit Singh from Wedbush. Sir, please go ahead.

Sanjit Singh - Wedbush

Congrats, Ken and Andrew, on a nice quarter. My question is regarding Q1, what do we see in terms of linearity with that in line with historical quarters, or was it – did it skew a little better?

Drew Del Matto

Good question. You know it actually skewed a little better, and you could probably see that a little bit in DSL actually, the receivable balance. So it skews a little better you’ll see a little benefit in collections.

Sanjit Singh - Wedbush

So I guess related to that, in Q1 we obviously had a number of high profile headlines attached with Target, Neiman Marcus. We had Heartbleed recently. How sustainable are these trends? I guess what I’m getting at is they have all these headlines and that’s driving some near term spending. Do you see any risk of that fading, or do you see other catalysts in your businesses? Do we have a core data center firewall, refresh going on that’s going to provide you some sort of some sustainable good catalysts as we look into your 2014 guidance?

Ken Xie

We don’t quite see it direct like acceleration when there’s this kind of news. It’s – because it is there’s a part of infrastructure and I think probably they can shop and educate the IT, the management long-term so sometime they may try to get additional protection or solution there. But if you look in the primary firewall pretty much all the enterprise they have Internet they need have some kind of protection. And something this kind of news they enable customer to add additional service or additional function to protect to do more protection. So that’s where – but I don’t see much directly linked changing into sales pattern here.

Drew Del Matto

Yes. I mean it’s just hard to imagine that these events won’t continue to happen and I just add to Ken Xie. I think one of the things that becomes more apparent and perhaps after the recent NSS test, I do think people are starting to look at the test because there – it is a bit of – there’s a lot of ambiguity as to kind of which one’s better and which performs and I think people are becoming savvy buyers, savvier buyers of security technology over time just like they became savvier buyers of ERP systems over time. And as the market matures and people become smarter, those tests are going to mean more. And the earlier questions are we getting any demand from that? You know, I think we’re very focused on trying to make the market aware of the value of the test and utilize that to our advantage.

Sanjit Singh - Wedbush

Great. And my last question, one of your primary competitors released a higher end data center focused solution. I was wondering if you came across that in the field during this quarter and how did you guys compete versus that particular solution?

Ken Xie

I think we have been in the – more strong in this whether the carrier of data center solution and that shipping the 5000 platform for 10 years. So the first few minutes so actually 10 years ago 2004 is the chassis based and the (indiscernible) solution with a lot of virtual domesticity in there. So really we are ahead of competitor both on the performance and the function on the technology and then I think that even a lot of since we are starting like what they delivered on testing today I think is we are ahead of competitor. We don’t see much competitor impact of what we have been doing. So far we’re leading this, we’re way ahead of competitors in this space.

Sanjit Singh - Wedbush

Great, thank you so much.

Operator

Thank you. And I am showing our final question comes from Erik Suppiger from JMP. Please go ahead.

Erik Suppiger - JMP

Yes. Congratulations on a good quarter. First off, I am just curious on your guidance for the second quarter it doesn’t show a lot of seasonal strength. I think typically you’ve had a nice uptick in the June quarter and I’m curious if there was anything in the March quarter that would have been kind of an anomaly why you would see things growing from there. And in particular I’m curious if you think that the various breaches that you saw from Target and the like in late December, in late 2013, if that was much of a catalyst for some of the demand that you saw in the March quarter?

Drew Del Matto

Yes, honestly, I’ll just take the last part of that first, Erik. I think it would be a bit premature. Most of the larger corporations that would have probably been impacted by Target are probably going to have some sort of a cell cycle and evaluation and I would think that, that’s longer than a three-month cell cycle, so we don’t believe we saw much of an impact there yet, but hopefully going forward. As far as guidance goes I would think of it this way, we outperformed in Q1 and we are guiding to 17% year-on-year growth, which is a level we feel very confident in. And based on our growing – and certainly that’s better than the 2x the market referenced that we were getting, right?

Our deal profile is changing so we’re shifting to larger deals, which generally have longer cell cycles. That, combined with new people – and we really are trying to be process driven on the sales side – campaign drive, process driven and some of those things. And I think for us, as we mature that process we’ll obviously, that will give us perhaps better comfort going forward or whatever. I won’t say we have a lack of comfort but there’s just a new process in place, new people, and we just want to make sure we feel very comfortable with what we’re saying with the guidance. I would say right now, currently, given all of that, our current forecast supports our current guidance.

Erik Suppiger - JMP

Okay, very good. Similarly, on your guidance for the year for the operating margin, when I walk through my model here, it looks like you are looking for a relatively flat OpEx spend. I thought it would get into the latter two quarters of the year. And I know you’re not giving guidance per se, but conceptually and mathematically, is that the right idea or why would you not be continuing to invest a little more aggressively than that?

Drew Del Matto

So again, we are not – it’s hard to address that right now. We’re not – we’re probably not going to give guidance more than we have on that front.

Erik Suppiger - JMP

Okay, very good. Thank you.

Operator

Okay, thank you. And this does conclude our Q&A session for today. I’d like to turn it back to your hosts for any concluding comments.

Michelle Spolver - Vice President, Corporate Communications and Investor Relations

Okay. I would just say thank you everybody. We went a little over on time, so thanks for everybody who is still on the call and listening through this. And we will have our second call in about a half hour, so anybody who has additional questions can feel free to call back into the call. There is a different call number it’s in our press release that was issued in our earnings release today.

Ken Xie - Co-Founder, Chairman and Chief Executive Officer

Okay, thank you.

Drew Del Matto - Chief Financial Officer

Thank you very much.

Operator

Okay, ladies and gentlemen, this does conclude your conference. You may now disconnect and have a great day.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: Fortinet's CEO Discusses Q1 2014 Results - Earnings Call Transcript
This Transcript
All Transcripts