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Fortinet, Inc (NASDAQ:FTNT)

Q2 2014 Earnings Conference Call

July 23, 2014 04:30 PM ET

Executives

Michelle Spolver – Vice President, Corporate Communications and Investor Relations

Ken Xie – Founder, Chairman and Chief Executive Officer

Drew Del Matto – Chief Financial Officer

Analysts

Brent Thill – UBS

Melissa Gorham – Morgan Stanley

Sterling Auty – JPMorgan

Jayson Noland – Robert Baird

Robert Breza – Sterne Agee

Jonathan Ho – William Blair

Erik Suppiger – JMP

James Wesman – Raymond James

Gray Powell – Wells Fargo

Jim Fish – Citi

Shaul Eyal – Oppenheimer

Daniel Ives – FBR

Operator

Good day, ladies and gentlemen, and welcome to the Fortinet Q2 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

Thank you. Good afternoon and thank you everyone for joining us on this conference call to discuss Fortinet's financial and operating results for the second quarter of 2014. With me today are Ken Xie, Fortinet's Founder, Chairman and CEO and Drew Del Matto, our 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 third quarter and 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 and more detailed questions, we'll hold a second conference call at 3:30 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 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 13 and 14 of the presentation that accompanies today's remarks.

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

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

Drew Del Matto

Thank you, Michelle and thank you to everyone for joining us today. Fortinet had an excellent second quarter. Our growth strategy and increased investments in sales and marketing's are paying off. As evidenced by our ability to exceed expectations across all key operating metrics. Please let me share with you, our financial results for the second quarter.

Our billings increased 33% year-over-year to $213 million significantly exceeding our guided range. Total revenue of $184 million was up 25% 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 above our guidance. And demonstrating the positive leverage of top line growth on the bottom line.

Finally, our cash generation remains very strong as evidenced by the $34 million of free cash flow generated during the quarter. Before diving into details, let me talk a high level about what drove our strong financial results. We've been later focused on expanding and improving our sales capacity and effectiveness and increasing marketing awareness and lead generation, especially in the US enterprise market.

This is to take advantage of the opportunities, we see the growth and gain market share and this is in fact happening. Not only did we see another quarter of strong growth and large deals closed, our enterprise business grew in the US, 73% year-over-year. We also continue to gain market share in the worldwide network security market growing 24% to 7.1% market share according to the latest IDC data.

During the second quarter, we benefitted from our recent investments in sales hires. Ongoing expansion with National Enterprise resellers in the US. Strong demand for our recently introduced FortiGate 3700D and 1500D enterprise security appliances and improved marketing effectiveness, which resulted in Fortinet's inclusion in more RFP's.

In addition, we experienced increased momentum and saw healthy spending within the enterprise. Primarily driven by firewall refresh and network upgrades. Network security threats are not going away, they are only increasing in number and sophistication. We've all seen this illustrated by the various recent high profile attacks and many others that don't make headlines.

This is elevated the security discussion to the board level and is keeping investments at or near the top of IT investment priorities. We are confident, in our ability to address this market opportunity and are optimistic about maintaining our momentum. As Ken, will discuss in a few minutes; we have an extremely strong and differentiating product offering.

This is boosted by the recent introduction of exciting new mid-range and high-end FortiGate products utilizing our FortiASIC NP6 processor that clearly set it separate from the competition. These along with our products and focus on effective innovation enable us to uniquely address enterprise and service providers next generation network security requirements.

Additionally, our FortiGuard security subscription services drive adhesive long-term customer relationship and a healthy deferred revenue stream for the future. Now, let me dive deeper into our Q2 results which can be seen on Slide 3.

As I just mentioned, billings were $213 million during the second quarter; an increase of $52 million or 33% year-over-year and significantly above our guidance range of $185 million to $190 million. This is strongest year-over-year billings growth we've seen in 13 quarters. From the geographic perspective, year-over-year billings growth was strong across all regions evidenced by the 40% growth in the Americas, which is also the strongest growth we've seen in 13 quarters and EMEA billings growth was 32%, the strongest in 14 quarters and APAC also performed well, growing billings 21% year-over-year.

In the Americas, we are very pleased with our continued success in penetrating large enterprise data centers and closed a number of deals with Fortune 100 customers in the US. We also benefitted from focused efforts in investments in expanding and deepening our partnerships with large national resellers to focus on mid-sized enterprises and saw billings driven through these channel partners grow approximately 70% year-over-year.

With regards to EMEA, our strong execution resulted in nearly all sub-regions over performing. We saw exceptionally strong results from the UK and Middle East as well as Central, Southern and Northern Europe. Similar to the Americas, we have benefitted from a strong return on our sales and marketing investments as well as continued momentum in capturing large enterprise data centers with our next generation firewalls.

Lastly, we were very pleased with our performance in APAC. Primarily driven by strength in Japan, especially with large service provider deal as well as from Southeast Asia, China and India. Our ability to close large deals during the second quarter was also impressive evidenced by the fact that deals over $100,000 grew 38% to $263,000 from $190,000 in the same period last year.

Deals over $250,000 grew 67% to 97% compared to 58% last year and deals over $500,000 grew 95% to 39% compared to 20% last year. We also once again had a growing number of deals over $1 million and our breakdown across our top five verticals remained relatively consistent with service provider at 24%, government at 12%, financial services at 10%, education at 9% and retail at 5%.

Now turning to billings by product segment on Slide 4. We continue to see diversity of product billings across all segments. Our high-end FortiGate products accounted for 40% of billing, up from 35% in second quarter, 2013 and representative of our momentum in selling next generation firewalls to large enterprises.

Our mid range enterprise products accounted for 26% compared to 28% last year and our entry level products which typically are deployed in enterprise branch offices and SMBs accounted for 34% compared to 37% last year. As a reminder, our product billings mix varies quarter to quarter based on the models of product, that make up all size deals.

Moving now to revenue; during the second quarter total revenue was $184.1 million up 25% year-over-year and was significantly above our guidance range of $169 million to $172 million. This over performance was primarily driven by strong return on our sales and marketing investment and healthy network security market that I mentioned earlier.

New product sales were also robust and contributed a product revenue increasing 28% year-over-year. We also saw a healthy attach rate of recurring services to these new product sales and evidenced by the net addition of $29 million to our deferred revenue balance, up strongly from the $19 million increase in first quarter, 2014.

On a geographic basis, you can see on Slide 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 31% to $78.4 million and now comprises 43% of total revenues.

Among the key deals in the Americas region included a seven-figure data center firewall deal with an existing Fortune 50 technology customer, which is one of the most recognized brands in the world. In this deal, we competed with and replaced CheckPoint firewall in various areas of their expansive and complex network.

Fortinet was chosen, due to our superior performance in capacity, high level of customer support as well as lower total cost of ownership. This was the largest deal in the Americas region during the quarter and this customer purchased dozens of our high-end FortiGate 3600D appliances.

We won another seven-figure deal with a large US financial services company that was upgrading its entire network security infrastructure and required advanced security and performance for several data centers in many remote locations. This customer purchased our new FortiGate 3700D and 1500D enterprise next generation firewall appliances to protect its data centers and FortiGate 200D and 800C appliances for its varying size remote locations, along with our FortiAnalyzer, FortiManager and FortiAuthenticator products.

VMC [ph] Juniper in this deal and beat out CheckPoint based on our superior performance advantage intelligent and detailed reporting and overall lower cost of ownership and finally, we won another large deal, which included our FortiGate 1500D appliances with a global service provider that is launching a new managed service to deliver secured, high-bandwidth satellite communications to business customers.

A key requirement was Fortinet's very high performance and the ability to adapt to and integrate with specialized home grown application. We won this deal over Cisco.

Now; turning to EMEA. Revenue with $62.6 million up 23% compared to $50.8 million last year and key deals included; a next generation firewall deal with a large European bank which was looking to refresh its firewall and consolidate with its intrusion prevention, point solution. They evaluated our products against a broad set of competitors including Palo Alto networks, CheckPoint, Juniper, Cisco and McAfee.

Fortinet was chosen for our strong IPS features and security quality as evidenced by our certified superior catch rate and significantly better next generation firewall performance. We also beat up Cisco and Juniper on another enterprise next generation firewall deal with a European based public services company that purchased, our FortiGate 1500D appliances with our FortiAnalyzer and FortiManager products to secure its network.

Fortinet was chosen primarily due to our unmatched performance as well as our ease of use and sophisticated centralized enterprise class management and analysis capabilities. Turning to APAC, revenues increased 18% year-over-year to $43.2 million from $36.6 million among the key deals in the region were, a seven-figure data center firewall win with an existing large service provider that needed increased capacity to support its growth.

We beat out CheckPoint, Juniper and Huawei due to our ability to deliver the highest performance and lowest latency in a real world traffic testing environment. The deal also demonstrated Fortinet's competitive strength and the demanding GPRS mobile data service network environment.

We also displaced Palo Alto and beat out Cisco and CheckPoint for the next generation firewall deal with a large university which was adding a new data center. They required a minimum 100-gigabits per second firewall throughput and 20-gigabits per second IPS.

They were able to achieve this with our new FortiGate 3700D. We won this deal based on our ability to deliver robust firewall and IPS throughput in a single appliance, secure virtual domains and server zone segmentation and a cleaner network topography to integrate with the existing infrastructure.

Finally, we won another large deal in Japan with one of the world's largest service providers and a global Fortune 50 Company. This customer purchased numerous high-end FortiGate products as the security platform to deliver a new virtualized firewall managed service for enterprises. We've won this deal over Cisco and Juniper based on the high quality of our products, responsiveness to the customer's specific requirements and overall best total cost of ownership.

Let me now review the revenue breakdown by product and services, which can be seen on Slide 7. Product revenues increased 28% year-over-year to $85.4 million driven by strong adoption of our new FortiGate 3700D and 1500D enterprise security appliances, which offer best in class security protection while also utilizing our FortiASIC NP6 processor to provide the fastest speed at lowest latency available in their respective category.

Services and other revenue grew to $98.7 million or 22% 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 strength. Also annualized renewal rates continue to be in the mid 70% range. As a reminder, our renewal rates are tied to the hardware.

So when a customer upgrades equipment, it counts as a new deal and not a renewal. With respect to headcount, shown on Slide 8. We ended the second quarter with 2,532 employees; a 16% increase over last year with the majority of the ads and sales. This is in line with our investment strategy to hire for growth with a focus on expanding sales capacity particularly in the Americas.

Turning to non-GAAP expenses and profitability. During the second quarter, consolidated non-GAAP gross margins were 71% at the high end of our guidance range. Non-GAAP product gross margins were 60% and non-GAAP service gross margins were 81%. Both relatively consistent with last quarter. Total non-GAAP operating expenses were $102 million during the second quarter resulting a non-GAAP operating income of $29 million or 16% of total revenue above our guidance range of approximately 13% to 14%.

Non-GAAP net income for the second quarter was $18.6 million or $0.11 per share based on $168 million diluted shares outstanding and above our guidance of approximately $0.10 per share. The non-GAAP tax rate for the second quarter was approximately 37% reflecting an increase in the annualized rate 33% in first quarter to 35% for fiscal, 2014. As a result of a jurisdictional mix shift, where we have more income generated in the Americas due to strong Q2 performance from that region.

And GAAP net income for the second quarter totaled $6.1 million or $0.04 per share compared to $9 million or $0.05 per share in the prior year period. A reconciliation of non-GAAP and GAAP financials can be seen on Slide 13 and 14.

Now turning to the balance sheet on Slide 10. In the end of Q2, with $911 million in cash and investments up from $888 million at the end of Q1. Looking at Slide 11, the increase was primarily driven by the $44 million in cash generated from operations. This was our 34th consecutive quarter of generating cash from operations exclusive of one-time items. We also remained debt free.

Free cash flow was $34 million in the second quarter; an increase over our first quarter after excluding the $20 million patent related settlement payment from Palo Alto networks. Annualized inventory turns for Q2 were 2.4, above our goal to manage inventory turns at 2 or better.

Our deferred revenue balance increased to $480 million, up $90 million year-over-year and $29 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 of FortiGuard's security services and FortiCare support, which generate recurring subscription revenue and provide stickiness [ph] with our customers.

Finally, during the second, we repurchased approximately 670,000 common shares for approximately $15 million. As of the end of June, we've repurchased approximately 3.1 million shares for a total of approximately $61 million at an average price of $19.60 under our $200 million stock repurchase program that we announced in December, 2013. $139 million remains available as of June 30, 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

Thanks, Drew. Fortinet's result over the last several quarter has been impressive and the second quarter further, our momentum. Our strong over performance in the second quarter clearly showcase that our core strategies paying off. Strong and consistency performance span an execution across all three geographies and continued strong momentum from our recently introduced high performance and the executed product are key drivers of our exceptional result.

As Drew highlighted, our unapprised sales in the US are of focus investment growing 73% year-over-year. And a number of last yield over $500,000 crossed in Q2, the increase 95% year-over-year. Additionally, we saw increase in large RFP's due to more effective marketing and winning a number of a large high profile deals with some of the biggest enterprise, financial institutions and service providers and award.

Fortinet's dedication to product innovation has always been our DNA with minds and the forefront of our business and continue to enable us to win and take market share against competitors. Customers consistently tell us, that our technology is the top notch and that is backed up the many third party certifications that Fortinet has been awarded for security factors.

These certifications as well as and buyers third party test matter. As Drew said, with a good technology from adjusted marketing. We are in an exciting point in hand and exciting point of opportunity for Fortinet. Trend such as increasing high profile [indiscernible] pack, enterprise network firewall refresh and consolidation of security functions, next generation high-speed network build up and cloud computing all have put, equity in the top of sea level mind and IT priorities.

I'm pleased to say that Fortinet put a line up and [indiscernible] map are the strongest it has ever been and we are in a excellent position to address and capitalize on these trends. Our FortiSandbox APT apprise, will only introduce a quarter into the market, has also been a high equally of a customer interest.

This many large enterprise clearly testing product in their labs. Additionally, customer adoption has already been exceptional high for FortiGate 3700D and FortiGate 1500D enterprise next generation firewall appliance. Which consolidates a good functioning and integrate FortiASIC NP6 to deliver up to 100-gig per second on performance in a single appliance and offer 40-gigabit connectivity for next generation enterprise network.

This product was recently introduced over the past few quarters and have ramp up quickly. In Q2, this product represent about 20% of FortiGate product building and it contributed to many of our large enterprise wins during the quarter. Several of which Drew just highlighted.

Our FortiASIC NP6 represents significant innovation and experience in our competitive advantages. Powered by our certified FortiOS network security operation system and our new NP6 processors FortiGate appliance deliver advanced threat protection and industry best price performance to the mid market higher enterprise and service provider telecom market.

I'm pleased to say, we have quickly bought FortiASIC NP6 advantage up and down of FortiGate product line. For the middle range, early this month we announced and begin shipping FortiGate 300D and 500D next generation firewall appliance that deliver 8 Gb per second and 16 Gb per second wireless speed, next generation firewall and IPS performance. Which is up to five times better than comparable price, competitive product?

Combined with a successful national channel partnership, we believe this product position Fortinet well, would take this share, in a medium enterprise market. And early today, we announced several new product, high end FortiGate 5000 chassis-based series, that integrate our NP6 processor to deliver 1 terabit per second of firewall support. This is the game-changer for Fortinet and to the market.

We are the first to actually deliver upon a promise of 1 terabit per second network security. The new FortiGate 5000 product including FortiGate-5144C chassis, FortiGate 5190CC [ph] and 519CC [ph] controller and FortiGate 5001D security blade that deliver 100 gig per second throughput. And enabled in a populate 14 slot chassis to deliver 1 terabit per second of performance.

This new fifth generation of FortiGate 5000 product firmly position Fortinet as delivering the world fastest firewall making it ideal security solution for carrier, service provider, not enterprise who has the most demanding performance as ability requirement or network security and a need for accessibility and deliver high performance application and network protection to the customer and the users.

Additionally, a change and improved security position on large enterprise that can segment, their network are now being in deeper security into the core without being prohibited by the historic performance bottleneck. One more recent announcement, I want to highlight early this month. We announced our FortiWeb VM, virtualized web application firewall product and now available on Amazon Web Service marketplace.

We are flexible, pay as-you-go on-demand model. Providing the security as a service further extends Fortinet broad cloud computing solution as well as provide customer more purchasing flexibility and ability to skill their solution to cause effectively made immediately and future need.

All of this wide and Fortinet competitive advantage considerably and are key drivers in our growth. Our result, over the last few quarters' show that we are executing well and our growth and investment strategy is working. The network security trend, I spoke of early combined with having the best product to address them present Fortinet which has a robust opportunity.

I'm confident in our continued ability to grow and take share and meet the evolving security demand of a current and future customers. Now let me turn the call back to Drew, who will give the discussion of our finance guidance.

Drew Del Matto

Thank you, Ken. I want to finish with our financial outlook for the third quarter, as well as provide some guidance for the full year 2014. Fortinet continues to benefit from the investments we've made in sales and marketing and product development. At the same time, as Ken just mentioned trends such as increasing high profile and sophisticated cyber attacks, network firewall refreshers, high performance next generation 40-gigabit and 100-gigabit Ethernet network build out and cloud computing are all putting security at the top of sea level minds and IP spending priorities.

With focused execution and a superior and differentiated product portfolio strengthened by new products that utilize our FortiASIC NP6 processor. I remain very optimistic about Fortinet's ability to grow and gain market share. As a result, we plan to continue our investments for growth strategy and believe it is the right thing for our business and that it will yield returns over the long term. That said, we intend to continue to invest reasonably and responsible and as we shown during the second quarter realized leverage on the bottom line, where and when appropriate.

With that in fact now, let me now provide specific guidance metrics starting with the third quarter of 2014, which can be seen on Slide 12. As a reminder, all of the guidance constitutes forward-looking statements subject to Michelle's cautions at the start of this call.

We expect billings to be in the range of $195 million to $200 million up approximately 20% year-over-year the midpoint and represents growth of approximately 3 times market analyst forecasts from IDC and Gartner. Total revenue is expected to be in the range of $182 million to $185 million up 19% 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 14% to 15% reflect in continued investments to drive growth and finally, we expect non-GAAP earnings per share to be approximately $0.11 per share based on an expected diluted share count in the range of $169 million to $171 million fully diluted shares.

In terms of 2014, we are providing full year estimates. This updated forecast takes into account the over performance in Q2 as well as our expectations for Q3 and implied guidance for the fourth quarter. We believe that this represents a strong growth outlook for the second half of the year, primarily driven by the ongoing benefits of our increased sales capacity and improved marketing and the momentum of our differentiated technology, which continues to drive market share gains.

As a result, we currently expect billings to be in the range of $835 million to $840 million up approximately 22% year-over-year at the midpoint. Total revenue is expected to be in the range of $735 million to $740 million up 20% 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 16% to 17% reflecting our continued growth investment, but still within our directional guidance range of 17% plus or minus a 0.1. and finally, we finally we expect non-GAAP earnings per share to be in the range of approximately $0.47 per share to $0.48 per share based on an expected diluted share account in the range of $168 million to $170 million fully diluted shares.

In closing, I'd like to thank our Fortinet employees, partners, customers and shareholders for their continued confidence and support. With that Ken, Michelle and I will now take your questions. Operator, you may start the Q&A.

Question-and-Answer Session

Operator

(Operator Instructions) and we will take our first question from Brent Thill from UBS. Brent, please go ahead.

Brent Thill – UBS

Good afternoon. Impressive enterprise business in the US and that was where my question was on, as it relates to the sustainability of that type of growth, you're seeing. I'm just curious, what you think has been the turn around there for you in terms of the increased tractions, as it relates to that surprise acceleration?

Drew Del Matto

Well, thank you, Brent. I think it's really three things I mean there's sales execution for sure, the new products are certainly a tail win and we absolutely have an improved network security environment. If I look at the sales side, I think we're doing a nice job of on boarding people and getting them up to speed faster in sales.

I think, they're also getting seeing the benefits of our you know, what I would say more focused market messaging and ability to generate leads from events and just various lead generation activities and then clearly, you can see on the product side 3700D and 1500D is doing very nicely.

I think, they're resonating very well especially in the enterprise. We really feel like the performance there is unmatched in the competitive landscape and that's what our customers are telling us and we see that really and you know very savvy investors tend to be buying our products, so you know hopefully they're at the front end of the curve and show what's going to go broader later.

And then just in general, you know it's no surprise anyone that the network security environment is robust. I would say that, we tend to see people buying looking to unify more functionality on a single device and I think our platform, our strategy plays right to that desire from the customers.

Brent Thill – UBS

Great. Thanks.

Operator

Okay. Thank you and our next question is from Keith Weiss from Morgan Stanley. So Keith, please go ahead.

Melissa Gorham – Morgan Stanley

Hi, this is Melissa Gorham calling in for Keith. Thanks for taking my question. I have a question on the high ends skews, you're seeing very good growth there. I'm just wondering particularly within the enterprise phase, if you could just maybe give the more color and kind of and where the boxes are going, are these met new opportunities, are you displacing encumbers when you're coming in, in the high end?

Ken Xie

I think, most of replacing some of the existing firewall whether they are, too old, too slow. All they lack of the integrated function because we see the trends early, is a lot of a refresh in E&P infrastructure due to the highest network environment. I think, time as a consolidation of a security function because they said too difficult, too costly to manage different box on different vendors, was rarely too enough consolidation, with customers hear the feedback, is really very, very important, not only save the cost but also easy to manage and also can look into getting better.

Drew Del Matto

Yes and Melissa it's true, let me just follow-up on that a bit. Certainly Ken's comments are spot on, but you'd asked the question I think very directly, are we acquiring new customers? The answer is absolutely yes. We really are seeing new customers and you know I would say that, exhibited in the deal sizes look at the deal sizes versus the past.

You can tell, we are kind of shifting up stream in the enterprise and those are new names for us. I think the other thing you see, is you know we have in terms of coverage, when we look at sales performance. The broad based distributions, it's not coming from just kind of existing sales people, who have been here for a while, I think they're doing well.

Well we could see, that we are kind of ramping up people and seeing them perform across the board very well, which certainly implies new name. So we absolutely believe, we are taking share.

Melissa Gorham – Morgan Stanley

Okay, great. Thank you.

Operator

Thank you and our next question comes from Sterling Auty from JPMorgan. So please go ahead.

Sterling Auty – JPMorgan

Yes, thanks. Hi, guys. You mentioned in your prepared remarks, a new segment of channel that's focused on the mid-sized enterprise. I wonder if you could give us some example of type of resellers that fits, have you not traditionally gone through that type of reseller and maybe what portion of the incremental growth is coming through this new channel?

Michelle Spolver

Sterling, its Michelle. The type of resellers are not necessarily saying that this particular reseller was responsible for driving the revenue, but the type of resellers that you would be familiar with would be, like FishNet, CompCOM it does national business across the US that's really focused on mid-range type enterprise.

So that came out for the first part of question. The second part, we have had relationship with those types of resellers, what we've done is part of our investing for growth strategy focused on the enterprise in the US is bit more focused, more attention, more investment, more resources too supporting and helping those type of partners grow their business.

The third part is, we did not break out and then we are not going to break out exactly how much revenue they contributed to our overall billings for the quarter.

Drew Del Matto

I do think, it's fair to say there were some channels opening up to us that probably didn't exist a year ago and that's a combination, I think of our investment and driving those relationships. I do think, some of them are actually looking for new relationship as they see some of the encumbers in the space maturing.

Sterling Auty – JPMorgan

Okay and then one follow-up, Drew. I don't know, I'm having trouble with access to slide, but I didn't see it on the slides about cash flow guidance for the year. Can you give us a sense of what you're thinking there?

Drew Del Matto

Yes, we are not really giving cash flow. We are not giving free cash flow guidance. You know what I could, you know I think what most people tend to do is model in line with operating income and then, adjusted for CapEx items and maybe DSO or inventory turns. If that's there Sterling and I can kind of give you the CapEx, we probably will spend another $20 million in CapEx during the year.

You know combination of some, we are growing. So we have some building up work in Sunnyvale and some other places and then we have an ERP project and few other items and so you know, maybe model, if I were modeling, I'd probably model $8 million of that in Q3 and maybe $12 million of that in Q4, it's a $20 million.

So you know again, cut up that's how somebody might think about it.

Sterling Auty – JPMorgan

All right, great. Thank you, guys.

Drew Del Matto

You're welcome.

Operator

Thank you and our next question comes from Jayson Noland from Baird. So Jayson, please go ahead.

Jayson Noland – Robert Baird

Great, thank you. I'm going to try some questions on NP6 products. So it sounds like, there is new mid-range solutions with NP6 and then the chassis was just announced today. Are we most of the way through the new product launch cycle regarding NP6?

Ken Xie

Not yet, NP6. Another process, we have a three [ph] key ASIC one we call the network processors, more go to the meter in high end and the countdown processor is rarely across the parallel line and also the SOC, system-on-a-Chip, more towards the lower end, mid range. So right now, we probably as half way of there, to refresh some of the appliance we have in the middle, high-end.

Drew Del Matto

Yes and Jayson just to clarify, I mean the 3700D and the 1500D were really the only products available for sale with NP6 last year in Q2.

Jayson Noland – Robert Baird

Okay and then the chassis specifically the 5144C has this been in the hands of carriers for a while, for beta testing, etc?

Ken Xie

There some has been and with some carrier, some other enterprise but it is still in early stage.

Jayson Noland – Robert Baird

And Ken, do you have much visibility and to how long that testing would take place and when you would start to see orders for this product?

Ken Xie

I think they tend to take, maybe 6 months to 12 months.

Michelle Spolver

Yes, some of the customers that are familiar with the products that might not take 12 months to test that product and some are testing them now, but I think the point is, that it's a longer testing cycle than it would be in a mid range product. So good to know, that you're question is going and how much revenue you expected in Q3 for that. I mean, it's a little bit longer for ramp up time, now.

Sterling Auty – JPMorgan

This will play out for some while, this chassis. Okay, thanks guys.

Operator

Okay, thank you and our next question comes from Robert Breza from Sterne Agee. Mr. Robert, please go ahead.

Robert Breza – Sterne Agee

Hi, thanks for taking my questions. Congratulations on the quarter. Either for Drew or for Ken, I'm wondering if you talk to sales capacity either be on the street in the terms of maybe qualitatively or quantitatively. How many people you've added and then as you invested in the channel, can you talk to us at least qualitatively how you think about adding capacity? And maybe your plans to continue to add that capacity. I'm really looking forward, how we think about going into FY' 2015 in the back half of year 2014.

Drew Del Matto

Well, I think we give a little bit of a trend on type account and where it's guarded. You could see, that we've grown I think headcount what do we think, 50% over a year ago, with really the bulk of that in sales, really a bulk of that in sales. I mean the market spend is some people, but it's other, you know it's obviously events and lead gen and that type of thing.

The way we characterize, the way I look at it, right now with getting into absolute numbers Robert, would be more about how people are performing and we look very closely at performance distribution and you know we can see the people who have tenure, you know say in the roles, certainly a year longer are performing consistently kind of at or above quota.

And then below that, they're actually performing nicely. You know, we don't have a lot of expectation for people who are here less than 6 months, but we are actually getting some productivity out of those people and you know that may well be more on the channel side or maybe they're brining existing relationship, but we are seeing good productivity between people coming on board mostly hit the six-month cycle.

They tend to be producing, you know I wouldn't say quite at quota, but very nicely probably a little better than I would expect and then certainly been here longer, people performing very well and very consistent globally and as we look at, where the investments have been focused. You know and I would stress the US enterprise has been the bulk of the good news and that's where the investments come.

Robert Breza – Sterne Agee

Perfect, thank you. Maybe a quick follow-up, Drew. I think, in your prepared remarks some you've talked, either carrying yourself about I think it was 20% of the bookings, I think came from new product or recently introduced products. Can you just, maybe add a little bit more color around the new product contribution to the acceleration and billings growth?

Drew Del Matto

What are you, I think the 20% is kind of tells that? Robert, what are you trying to get out?

Robert Breza – Sterne Agee

Probably speaking more, as we think forward as you introduce new products, is this trend likely to continue as people look till you drive increased capacity in terms of the newer products as customers are driving to this refresh, is it really about being etc capacity, that was more of that thought.

Ken Xie

I think the two products made about 20% contribution in Q2 is the 3700D and 1500D. There are some, we've tried some new opportunity but also replacing some of the old product on the 3000 series and also 1000 series. There's a combination of met new ad and also some of the old product replacement.

I think each new generation $10 billion for the performance 3x to 5x better than the previous generation because the ASIC chip because the CPU because the other network device, the chip we put in to system. So that's I think is the new contribution, from the 20% but if you look in all the, it's about 40% of this come from, we call the high end product. So that's where the two new product we introduced starting ramp up over quickly.

Drew Del Matto

Yes and I just to add, Robert. I mean a little bit kind of gets back to Jayson's question about cycle times or you know how long, things in testing, how long do they take to ramp up? We announced the 300D and 500D earlier in July, again people are really just getting their hands on those products and it takes a little while.

I think, as you go kind of downstream maybe some of them come quicker but you know as you're looking the, where we have been focused one of the hard things about, what we are doing is, a lot of newer investments in sales and marketing around enterprise customers and you shift up in the enterprise, you know we're really trying to get a beat on how long that deal cycle is and that's a little tougher to predict, especially with a lot of new products and a lot of new people, but that being said I'm kind of looked so somewhat fresh to reporting that.

I've gone back and looked at history because I'm interested in same question and when we've had product releases, you do see, you certainly see a tailwind over a period of time. I'm not sure, it's immediate but definitely there is an uptick at some point.

Michelle Spolver

And the last thing I would add to is that, I mean, you're excited about the new product that robust set of products and it is built into the increased guidance that we've delivered.

Ken Xie

And also, company want to say, if you look in the high end product like 5000 chassis base, most equal to service provider take a little longer testing time. The 300D, 500D is relative to the middle range, as probably will be ramp up soon and quicker. The 3700D and the 3000 series and the 1000 series probably in the middle. So that's where, like when announced this quarter the 300D, 500D that's probably ramp up maybe faster and then 5000 tend to take a little bit longer time to in the testing process.

Robert Breza – Sterne Agee

Very helpful, thanks.

Ken Xie

Thank you.

Operator

Okay. Thank you and our next question comes from Jonathan Ho from William Blair. So Jonathan, please go ahead.

Jonathan Ho – William Blair

Congratulations on the strong quarter. Just wanted to get a little bit more of a sensor around the verticals that you're seeing to strengthen for the enterprise products. I mean, are there any particular verticals that standout or any areas, where you're seeing more distribution channel traction?

Drew Del Matto

You know it tends to be, also bit qualitative but I would say that, it tends to be the most savvy customers. You know, what I when I look at the names they tend to be tech savvy customers, kind of cutting edge looking for kind of, definitely looking for that blend certified security performance along with fast network performance.

You can go into the tech space definitely, there is absolutely some financial services in there and there is always a bit of carrier, of course.

Jonathan Ho – William Blair

Got it and just as we take a look at sort of the traction that you're getting through the distribution channel, I mean how would you sort of attribute the success between either you've seen an increased number of opportunities or bake-offs versus a higher win rate, like have you guys seen traction on both side? Just want to get a sense of where that defense are showing up.

Drew Del Matto

I think it's both. Yes, we do very well – we've always done well at bake-offs. I think we are getting and we are absolutely getting more attention. I mean people are telling us, they would like us to give more attention, in fact that's a feedback.

Michelle Spolver

Yes and that is been our challenge, more of the challenges in the past to compete in the bake-offs. We do very, very well. There's opportunities out there, that we want to team in because lack of awareness as for whatever, but we did talk about in our commentary that we were saying, what we did in Q2 seen increase in, being included in RFP's which certainly help us more business driven through the mid-range channel, low-end channel built in through usual, which is good.

Drew Del Matto

Yes and to be fair, I mean, we've certainly invested more in marketing to get that awareness out there, but we still view there's opportunity there, that would be the feedback that we've seen and we absolutely take that seriously and we will continue to invest.

Jonathan Ho – William Blair

Got it, just in terms of the Wi-Fi access point market. Can you guys maybe talk a little bit about sort of the products that you have there and maybe some of the traction that you guys having on that side?

Ken Xie

Yes, lot of old customers especially lot of under price, we're starting to see the need of expanding Wi-Fi, but also they're frustrated about, have to have two infrastructure, two kind of way to manage wired or Wi-Fi. So that's where 40-gig is kind of where, UTM or on EDGE and firewall.

We build some Wi-Fi controller function in there and we used some extend, AP is world-wide enterprise customer. So they see it's lot easy, simple to manage but also wired is environment. So that's where we see some healthy growth. Eventually, small but as we see the ramp up pretty quick.

Jonathan Ho – William Blair

Great. Thank you.

Operator

Okay. Thank you and our next question comes from Erik Suppiger from JMP. Erik, please go ahead.

Erik Suppiger – JMP

Thank you, congratulations. I would like to have some perspective on how much of the acceleration you've seen in your growth sequentially was really attributable to stronger market versus how much change in your execution. You'd said that you're seeing refresh cycle pick up, was that material improvement or material change from where you just in the March quarter or how much has the market changed just in the last 90 days?

Drew Del Matto

I don't think much. You know, look I think part of it you need the capacity to actually go talk to the customers and bring in the orders, but I think again the blend of having some level of awareness, what quarter that is, who they're are and what we represent, that product brand awareness before we go there, so that we can get in the door and sale matters and then having somebody actually go in there and calling the customer.

So I think, that makes a big difference. You know if you go back, a year of the capacity, just would have been there. Now over the last and then the capacity or the productive capacity certainly increased in the last three months. I haven't seen a huge shift in the market. You know I mean, the headlines continue but I don't know that they have drove any immediate change and how people are spending and in last 90 days.

Ken Xie

I think compared to one year ago definitely the market is better, but we still also waiting for the overall market data like from IDC or Gartner try to see what's it hold, this year, the whole market growth definitely will be better than last year, but have to see compared to Q1 as Drew said, not a lot of difference.

On other side, I think new part we are starting to see a lot of advantage like just we are now supposed to 1500D, which company in Q2, but also the 300D, 500D. We say the 5x matter on the next gen firewall performance than the comparative product. So it is really we see, more advantage, more differentiation of our product comparison, compared to product.

Erik Suppiger – JMP

So if it's really driven by some noted changes across your product line and your execution. Why would you expect sequential decline in billings as you go into the September quarter, is a seasonal effect or what would change going into September?

Drew Del Matto

Well, look I think you know we had a very strong Q2 and I think, also when you look at the comparative versus Q2 last year, it was bit of a lower bar relative to Q3. I would also note that, we are upping our guidance, we were saying 2x the market, now we are basically saying, we are roughly saying 3x the market, so that's a lot.

I would also point out, look we have a lot of new people, products, systems and processes to follow and you know so we are being very prudent and you know calling it, like our people see it, you know today again I would say we see pretty good model. But you know we feel like, we have a better pulse on the ability to be affective in any given point and time base on the front and you know that's how we are kind of getting up.

So I would look at more of kind of glass up full, with a glass half empty situation quite frankly.

Erik Suppiger – JMP

Okay, fair enough. On the competitive front as you've expanded a little bit into the mid market and had some real good penetration in large enterprise. Are you seeing any vendors more than you were before, if you look at kind of incumbencies Cisco, Juniper, CheckPoint or any dynamic changing there and then do you see any change in terms of competition with Palo Alto?

Ken Xie

Not much in, I think we also start and had some marketing that is few some time the middle market, you probably need a bit more marketing to get in there and also we are working closely with our channel partner. They're starting to see the benefit of the product, but from competitor side I don't see much difference maybe few, Michelle any?

Drew Del Matto

No, I think that's fair.

Erik Suppiger – JMP

Okay, last quick question. Juniper yesterday had noted some carrier changing behaviors with carrier CapEx that was kind of clouding visibility have you seen any change in terms of carrier priorities of where they're putting their investments or any change on the service provider front?

Ken Xie

No, we did not see much change.

Erik Suppiger – JMP

Very good. Well, thank you and congratulations.

Ken Xie

Thank you.

Operator

Thank you and our next question comes from James Wesman from Raymond James. Please go ahead, James.

James Wesman – Raymond James

Good afternoon, most of my questions have been answered. Drew, just a quick question on cash flow. For the year, I believe last quarter you'd said you were comfortable with about $36 million or $37 million and modeled cash taxes for 2014, are you still comfortable with that?

Drew Del Matto

Yes.

James Wesman – Raymond James

Great and then just a quick follow-up. In the quarter, can you guys just talk about the linearity with it, where your expectations were did you find the quarter was more back and loaded, any color there would be appreciated?

Drew Del Matto

You know and I think this came up last quarter, cash flow. We have a very, we had better linearity than we had traditionally. I think in Q1, we had very consistent linearity with Q1 let's say, so it had approved over the prior year and the year's before that, it's actually becoming more linear and you know perhaps the channel, it has something to do with that, where that's more of kind of, if you know think about the larger direct stuff tends to be more back and loaded, whereas channeled businesses tend to be more flow handed if you will, even flow.

James Wesman – Raymond James

All right, thank you guys.

Operator

Thank you and our next question comes from Gray Powell from Wells Fargo. Gray, please go ahead.

Gray Powell – Wells Fargo

Hi, thanks for taking the questions, just a couple. So hopefully you haven't touched on this too much yet, but can you talk about the investment in sales and marketing and specifically just where that's going, is that more enterprise sales reps or investment in the channel or buying leads or maybe something else, you're not thinking of?

Drew Del Matto

You know, it's those things and I mean, you know, we're really I mean that's right we're buying sales – absolutely investing in sales capacity. I would say any one area, if I had to pick out anything. Singularly focused, I would say probably mostly the US enterprise. I think that probably comes across in the results as well, we continue to believe that's an area of opportunity for us.

I mean, if you look at us we are 43% US, most tech companies probably have a little higher weighing on the US and we feel like, we have a little relative opportunity there. Let's just say and we would circle the US enterprise as what would potentially get us closer to 48% or 50%. I would make that – stick at those numbers but, it's kind of how we think about it, if you will and you know that takes feet on the street.

It takes some channel and then it takes some awareness as well and you know, we are doing more events absolutely, more trade shows and a lot of lead gen, quite frankly. And that's all I would think about it.

Gray Powell – Wells Fargo

Okay, that's helpful and then you talked about customer interest in your new FortiSandbox appliances. Does that, have a material contribution in Q2 and how should we think about that for the second half of the year, could that be a more meaningful impact as we look to Q3 and Q4?

Drew Del Matto

I would say it's a bit early, I think we've seen our product basically came out in March. I think we are getting really, I would characterize that it is very good interest, we are seeing quite a few trials, hard to predict when those will close, I don't think people are, as we our sales were up, when will this close. You know they're just saying people are really evaluating the products very closely at this point.

So kind of hard to predict and you're coming off a low number. Again, so you know when you do close the deals just keep in mind it's going to be a very low day and so it'd be hard to expect a huge contribution over the next six months.

Ken Xie

Also the FortiSandbox, we have the benefit actually working together with FortiGate. So which kind of linked together for then provision to the attack, compared to some other vendor whether they are working with separate vendor in the firewall and some detection mode, so the combination of Sandbox and FortiGate. We get quite well position, well welcome by the customer because they kind of make all this total solution, working together well.

Drew Del Matto

And I think that was one of the items, I was trying to point out earlier, where we're looking at the drivers. I think the first question I got, what were the drivers of the quarters and we absolutely do see a desire from customers to consolidate functionality on network security platform and that's one of the advantages we have with the scope of our products.

Gray Powell – Wells Fargo

Got it. Okay, that makes a lot of sense. Thank you very much and congratulations.

Operator

Thank you and our next question comes from Walter Pritchard from Citi. Mr. Walter, please go ahead.

Jim Fish – Citi

How it's going guys? It's actually Jim on for Walter here. Kind of going off the FortiSandbox you know with a full quarter of that, now under your bulks I believe, you launched the end of 1Q. how are you seeing this being sold with, is it more new budget or is it shifting budget around and is it more, are you able to get kind of more customer based off of that given kind of what happened with the NSS test?

Drew Del Matto

Yes, definitely the NSS test is out there, you know I don't -- if you guys saw those reference in the New York Times article yesterday. We haven't again, as we just said we haven't thought a lot of it yet and so it's hard to predict that budget will come, you know those conversations really are to follow, but again I think it goes back to the consolidation around network security platform.

I would have to imagine that, there are other areas of security that will probably continue to commoditize, so I think that provides some of that opportunity some of that funding but you have to also believe that security, one of the other dynamics I mentioned is simply that security is a high priority. It's hard to imagine that it's not on the top two or three of any priorities.

And so ultimately, if people have a limited budget, it's going to crow something else out. There is something else, they're not going to do or not renew and that would play to our favor.

Ken Xie

Yes, I think as somehow my feedback is kind of more come from some additional new budget because of the high be on a current like, what are firewalls, some other security, but on the other side, it's a lot of strong demand is ready to be act together with firewall to prevent our attack instead of just reporting there in the next layer, probably tried to detect, and then you cannot take an action kind of makes it even worse, as a kind of hinders a lot of us.

I mean kind of make a lot of even worse, if you only detect and cannot take action. So that's where we see the situation has to be combined together with the network security anyway and working with Sandbox together, so it's total solution is very, very important to prevent attack, instead of just detect.

Drew Del Matto

And Jim one, you know one important I think feature when you think about how budgets happen and how people afford to buy those who make room. We've met with a couple of customers, larger customers. Who say they're under pressure to reduce their IT budget, but improve their security effectiveness and they like the idea and this goes back to the point of consolidation around a single device unifying around a single network security architecture.

You know because we can actually help them do that and again these are in terms of sales cycle, it takes a little longer time to do that because it's a broader architecture than a individual point in a network. It's kind of a broader platform architecture, but you know that is something, that we're, you know when I talk to customers, certainly that's come up several time, how can you help us reduce overall cost. I know, I think I'm getting pressure on both sides, I have to do this.

I have to increase my security effectiveness but at the same time, I'm getting slammed on my budget and you know, I think we're uniquely positioned to help people do that.

Jim Fish – Citi

Okay, great that was great guys and then just one more from me. In terms of kind of going off, what lot of others here are saying, with the sales and marketing, hiring. Should we think about that accelerating in terms of actual position like throughout like in the back half of the year or should it be kind of just stable from here on out.

Drew Del Matto

You mean stable hiring or?

Jim Fish – Citi

Yes, are you looking to accelerate hiring into the second half from what you did already or is it going to be stable relative to what you've done in the first half.

Drew Del Matto

Well, we're going to continue to invest. I think, we gave the margin guidance. So I think it's generally consistent with the ramp, we have been on.

Jim Fish – Citi

Okay, great. Good quarter, guys.

Drew Del Matto

There's a little bit of, quite honestly I have to take August into account globally people are on vacation, holiday's and how fast you can actually bring people in the door and sometime it's, I think the last quarter, I just anecdotally is probably a better quarter to hire people. If you get in the summer months, it's a little tougher as you approach the fall through the end of November probably little easier, slowed down in December.

Jim Fish – Citi

Okay, great. Thanks guys.

Operator

And our next question comes from Shaul Eyal from Oppenheimer.

Shaul Eyal – Oppenheimer

Thank you. Hi, good afternoon, guys. Impressing results, congratulations. Drew, one more question on the hills [ph] of the prior and the sales and marketing and hiring. So you guys ended the quarter, a little over 2,500 headcount. What should we be expecting by the end of fiscal 2014 another 5%, maybe 10% increase in headcount, maybe just a range?

Drew Del Matto

Yes, I really don't have a range on that. I think, I would just go up the mark. I would go off the margin guidance, it's just too hard to predict.

Shaul Eyal – Oppenheimer

Fair enough, now as you guys continue to bring in people and the business accelerates, can Drew – what's the thinking about the COO position, to looking or is it something Drew that you're running going to be officially running?

Ken Xie

We will keep the field position open, I think and we also keep in recruiting the other executive, who can help in, if we're not keeping growing, keeping like meet us to the next stage.

Shaul Eyal – Oppenheimer

Got it. One final question, really high level question on the product front. So when looking at the high end data center, high end high pricing product. When the customer is finally making the investment decision to put this money to work? Are you think cases, whereby customers will be buying a growing number of those appliances driven partly by increased redundancy needs, is that part of the decision making process on the high end front?

Ken Xie

I think, when they design architecture in the beginning, the designer is not in there, so that's where we see a lot of opportunities ready with fresh, of the old infrastructure relatively slow and also the lack of the some of the security function like whether the mall work detection prevention and all the intrusion and the application kind of come in.

The redundant especially for the service provider, some data centers quite important should be in there already but is, I think the new product, we'll be launching like the fresh out in today and also some other. It's a fifth generation, we're launching the 5000. For all, this is five generation, they all have the redundant to make us probable in business is needed to change.

Shaul Eyal – Oppenheimer

Got it. Thank you for that, Ken. Really helpful, congratulations.

Operator

Okay. Thank you and our last question comes from Daniel Ives from FBR. Daniel, please go ahead.

Daniel Ives – FBR

Thanks for fitting me in. So certainly, on the high end obviously lot of strength in the large deal especially over $2,550,000. I guess the question is like, a year from now I mean do you that as the bigger and bare component. Obviously, have been a key part of your success. I'm just trying to understand the strategy going forward. In terms of on the high end, how much you're going to sort of bet there, what products and executions.

Obviously been massively successful within over next six months. How much more room you think, you have to go, is that the most fertile opportunity on the hand? Thanks.

Ken Xie

I think so far, we see the architecture, the platform we have with the combination of our own ASIC with the CPU and also other chip on the market. We started the fresh and more with the competitor, most of them only depend on the so far CPU to deliver function. So when you try to have a consolidated function or the function also, try to meet a high speed new infrastructure demand. The 40-gig platform tend to perform and function much better.

So that, I think you can see the new chip we put in the 500D it's really a lot of our advantage and also the middle, we also believe the new 5000 will also apply an additional advantage we have, I think that's probably more towards the high end and then we also have the chip. We code SOC, the system-on-a-chip and that's also applied at the low end because that can lower the cost, that's the benefit of ASIC.

You can improve the performance compared with the sell for the loss [ph] a lot like, mentioned like a 10x above and also you can lower the cost, once the quantity is larger. So it's kind of atoning how the skill, so once we have the skill. We have the number, we can also lower the cost, not only on the system but also some other operation cost.

So that's where we see some benefit on both end, but it will also take time. So we need to take time to ramp up the new product, we also need to take time to really build the infrastructure, build a team to reach our level.

Michelle Spolver

Okay. Well, operator. I think that was our last question, I believe. So I would say, we have another call at 3:30 Pacific Time for those of you, as you're working through models and your follow-up questions. please feel free to call back and if that time, there's a different calling number, that's in our press release, but thank you for taking the time to be on our call and looking forward to, talking to you again at 3:30 and then throughout the quarter.

Operator

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

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Source: Fortinet's (FTNT) CEO Ken Xie on Q2 2014 Results - Earnings Call Transcript
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