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Ken Goldman – Chief Financial Officer

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Brent Thill - UBS

Fortinet, Inc. (FTNT) UBS Global Technology and Services Conference Call Transcript November 17, 2011 11:00 AM ET

Brent Thill

Thanks. We are going to get started. My name is Brent Thill. I run the research initiative at UBS on the software side and the security side. Pleased to introduce Fortinet’s Ken Goldman, Chief Financial Officer.

Ken, as many of you know is an industry veteran in the technology industry, prior he was the CFO of Siebel from 2000 to its acquisition by Oracle in 2006. Prior to that time he was at Excite@Home, Sybase, Cypress Semiconductor and VLSI Technology. So, Ken thank you very much for being with us today.

Ken Goldman

Yeah. Hi, I hope there isn’t echo here, plus is the webcast working okay and all that stuff?

Brent Thill

Good to go.

Ken Goldman

Great. Good. Okay.

Brent Thill

I guess just –

Ken Goldman

By the way, let me just make the courtesy disclaimer, but to the extent that I do talk about forward-looking statements, the various risk factors, fully covered in our public filings including our latest Q for the third quarter and K for last year and so forth, so all there and nicely laid out for you folks. Great to be here.

Brent Thill

Ken, maybe if you can just start at the high level. Fortinet is one of the fastest growing companies in our space and certainly in the security space, you are outpacing your peers by a pretty material rate, plus 30% growth this year. What are the demand drivers that you are seeing in the high level that are enabling us and what is the real competitive advantage from your perspective?

Ken Goldman

I think it’s actually – really going through and thinking through what’s going on right now and I think from a macro point of view you certainly have a lot of changing networks and infrastructures which in various threats they keep on increasing, given the internet and the mobility and the folks that try to sort of find way into the network. So, in some respects, you have that going on.

I think the other thing that is happening, honestly is normally you have this world that is changing and mobility and virtualization and all of that, but I think interesting enough, I think which really drives an industry is the innovation cycle has come back. I think there was a period of time when perhaps, a few years ago where there wasn’t a lot of change in innovation, but if you look at what we are doing with the UTM, you look at the firewalls and the activity there and you look at various application controls, there is a lot of innovation. In my experiences, when you have innovation, that sort of – just oppose it really accelerates the growth. And so, in the UTM space, generally the growth has been in the low teens. We have been growing 2 to 2.5 times of that. But I think you have an environment where security is front and center of any data center manager or CIO, it is front and center of the retail industry because of various regulations they have, front and center of healthcare in terms of PCI – in terms of HIPAA in various requirements there, you have the governments all focused on it, you have the education environment.

So this is an industry that is pervasive in terms of whom we can sell to, in terms of various verticals, it’s pervasive across the world and so you also see today it is not a US centric or European centric but it’s a global environment. But I do think after watching a little bit, I think one of the things that has fundamentally changed in the last year or so, there is a lot of innovation going on which is propelling this industry even further from a growth point of view.

Brent Thill

You have obviously been dominated – the revenues were dominated by the ATM appliances. When you think about some of the other solutions that you’re selling, can you just give us a sense of what you’re excited about and what we should be watching?

Ken Goldman

Yeah, I think the FortiGate story still represents – you can call it 85 to 90% of our business. We do so with that which is becoming more and more important to sell is the FortiManager and the FortiAnalyzer because as the environments get more complicated and comprehensive as they go higher up in the enterprise there is no question you seem to need now more and more so for the ability to manage this and having an user interface easier.

The other products we sell, whether it is the FortiMail, FortiClient, FortiWeb, FortiScan, a variety of products, in the main probably add them all up, it’s around 10 to 15% of our business. It is an important part of our business. We are trying to grow it further, it’s a focus of ours but at the end of the day FortiGates are still certainly the bulk of our business and will be for quite some time.

Brent Thill

Wall Street got focused last quarter on Europe and I think you proved that that was a short-term hiccup. I guess from your perspective maybe give us your view kind of after you are digesting what went on and what you see now going forward, kind of how do you look at that and what is happening with Europe?

Ken Goldman

Yes, Wall Street says it just like to focus on a fire, there is no question about that. I remember that (inaudible) call in Q2 and some analysts not my good friend over here who was asking me did I know how the stock was going down, I said, yes I think I sort of did know that. I did remind him after this quarter, did you see how the stock was performing after the market and he did notice that as well.

Yeah, I have been doing this for a long time. I think I have some sense when the old issue of – there is a bunch of cockroach, the first one or not. And I think I tried to suggest with some people believed me, some didn’t, that I didn’t think we had a fundamental issue in Europe, but I felt that we had some specific issues that we could have executed better. I am going to now reacting to Q2 – second quarter, I also felt the environment was clearly not as conducive maybe and we did have some critical unrest in the middle-east and that has been an important market for us.

We had improved performance in Europe last quarter, I wouldn’t call it great yet, we still have work to do. I think we grew our billings in the low teens, actually our revenue is growing quite strongly in Europe. If you look at our revenues, which is what most of our competitors, they only report revenues. Our revenues in Europe grew about 30% – or EMEA grew a little over 30%. So you had good growth in revenues. Billing still need to go up, we do talk about that a lot, without sort of giving expectations now for 2012. There is no question that we are going to focus on how we can accelerate growth in Europe. Even more so and we are doing the things we need to, I think to help that.

Now, all of that is covered by. We are also mindful of the economic environment there and watching over that as well. But again, I think we always have a sense “do we have something systemic as an issue or not?” In my opinion, at the end of the second quarter was it wasn’t systemic and to the extent if it was systemic I would have said that it was systemic in my opinion.

Brent Thill

Your competitors like to paint a picture that you are a mid-tier vendor and then clearly from the metrics that, that you are showing that is simply not true and when you start to look at the enterprise accounts that you are winning, I think you mentioned a pretty large retailer that’s taken this at a number of different spots. When you think about, where you think the company is headed and kind of shutting that image, can you just give us your sense of what is happening in here?

Ken Goldman

I think there is no question, if you go back in history, it is part of which, we having the strength in UTM and people believe in and you can’t do everything and not give something. So you have that going on. And honestly, part of it was the way we were structured, particularly in the US, in which we had a holistic organization which really is focused purely in the channel and so we in general did not address the higher end. Now, if you look at it today, and by the way I am not going to come back to, because we do have a lot of work to still do there. But if you look at today, about 37% of our business we said quarter was in the (inaudible) high end 1000 to 5000 Gates, in the FortiGates.

If we look that US, we broke up the organization and I would just take out the organizations of enterprise, financial services and federal and look that as a part of our Americas business, you know that is close to 40% of our business as well. So, we are doing about 35% to 40% of our business really what we consider to be an enterprise accounts. You look at that, I think we did 13 deals last quarter, over a half a million and so we are seeing consistently going higher end. If you look at some of the rest of world, we have always been structured in a way to address the higher end, the enterprises and the organizations, service provider represents about 25%,28% of our business as an example.

Where I think we still have work to do however, there are area that we have not be adequately focused on, financial services in the US, particularly in New York, right here, right where I am sitting. You want to rebut [ph], okay I saw you some no. It is an area where we can absolutely do better, we want structure, (inaudible) organization up until about a year ago, there was really focused on here. So, we didn’t really have the, some of the main knowledge of what it took to compete in this business and I frankly think our marketing positioning could have been better, I mean sometimes you sort of have to do less with more to make more and by that I mean, if we just sometime sell our product as a firewall, we can clearly compete on pure performance and we do that all the time, but we are not necessarily thought of that as a competitor and yet we do have performance which is equal or better than all of the other major players out there.

So, part of it is frankly some market positioning that I think we’re still working and wrestling with internally. How to drive it even more so in the enterprise and part of it is sort of just in the image for the company, but the reality is the facts are across the world over a third of our business clearly is in the higher end enterprise business and that was, I don’t have the exact numbers but you can probably say as (inaudible) low teens if you will four or five years ago. So, we have made progress, but it’s fair to say we do have more to go as well.

Brent Thill

You have been fortunate given some of your larger competitors have been wounded in their security go-to-markets and security strategies and when you think about what’s happened there and given you that room, I mean, how do you look at the competitive landscape now? I mean there has been a lot of talk about what Palo Alto’s doing at the low end coming up and seems like Cisco is getting a little more focus at least in the recent announcement of trying to get their act back together, what is your perspective and how this is shaping up?

Ken Goldman

Yeah, I think we and some others have effectively taken advantage, if you will, the fact that both Cisco and Juniper are probably haven’t focused on security as much as they had been and you know actually in both cases the numbers year-over-year have been down. I think actually, Cisco may have been flattish last quarter, so. But, whereas all of us, whether it is checkpoint to ourselves and others have been growing at 25% to 30% range. Juniper and Cisco which have, you know have a large overall security market shares not necessarily UTM, but overall market shares, they have been sort of flattish to even down. My sense is they are, you know that certainly Cisco has acknowledged that, they have talked about new products coming out, Juniper of all things have talked about new ASICs in terms of their products, (inaudible) ASIC’s but Juniper actually now talking about ASICs for their appliances and so we don’t take anyone lightly, honestly. So, this is an area though, that as I look at it and see how you compete, I mean people always ask how do you compete? Question I used to get is, how do you compete against Cisco and Juniper?

You know, my experience is always in technology, if we have a better product and you are able to sell it well and prove your value add, you can compete with the folks that are much larger than you. As a matter of fact is that, sometimes it is easier to compete with those, than those with other innovative players that are maybe the same size as you. So, I have no problem of it, I have never had a problem when competing with larger players as long as you out innovate them and a lot more flexible and quicker on your feet and more aggressive. So, that has been our approach, the reality is where a three or four years ago, we were $130 million, $150 million company, where we clearly, when you look at a run rate point of view last twelve months, quite a hell of you want to look at it. Well over a 400 million revenue company, not quite 500 million in billings this year, but was certainly, you know if you look at the numbers, we are getting there.

So, you look at the size of the company, we are pretty large company ourselves. And so, I think we are one of the companies that did benefit from the additional branding if you will, perception, and knowledge, and visibility of being a public company and competing in the public company and now we have a very strong balance sheet to support that.

Brent Thill

You mentioned last call there is a product, refresh wave coming, how should we think about products over the next year? Is there more of an incremental step function in terms of things that will come or more just a refresh that kind of goes through –-

Ken Goldman

I think you will continue to see, without sort of giving any pre announcements here in terms of products. We continue to refresh our operating system about every two and half, three years. So, you will see that, I am not giving exact times here. We continue to refresh our entire product line also in a pretty much two and half, three year timeframe. If I look at our products, you know, I don’t know, 60% of our revenues come from products in just last couple of years. I mean, we are seeing that kind of continued refresh and so we feel very good about products. Already introduced this quarter, frankly the biggest challenge we have is getting enough availability and ramping up production, which is something we talked about in Q3.

So, getting availability of the newer products, but I feel very, very good about that coming out this quarter as well as next quarter. We don’t tend to have, we are not like a big box company, where companies stall and don’t buy, they wait for the next generation, that doesn’t tend to happen here, so. What happens here is, as the new –- every quarter we do have new products come out and that is one of the areas that does give us the strength for that particular quarter. But it doesn’t tend, it tends to get melted if you will into our overall numbers, so you don’t see it necessarily and the increment that you can detect from products, but that really is what drives our overall growth quarter-to-quarter.

Brent Thill

You had an inventory shortage in Q3 and usually that’s a good thing, because that means demand is good or it could be a bad thing because of the you don’t have, you got some production issues, I mean, can you give us a sense of what happened and is that under control now?

Ken Goldman

Yeah, we didn’t have production issues. The issue we had really and, you know there is always a balance, you know just like perspective, I came into the company a few years back and what I saw is, is a situation where, we were frankly in my opinion out of control in terms of our inventory planning and so we went through a very formalized process, in which we really do look at not only the demand, the demand forecast, we look at trends and we tried to balance, having no backlog, backlogs is not good particularly in a channel you don’t want backlogs. Because then you have missed orders and you lose those, but what you don’t also want is, where you have some pure play products for certain customers and you build too much and end up having excess.

So there is a balance there and frankly I thought when I came to the company, the balance was too much. In terms of too much inventory, we wrote off a bunch, fortunately we were still private, so none of you had to see that. And I think we probably went a little too far and so we are going to butch [ph] up our inventory and stock, if you will, maybe a little bit more in terms of what the channel has. And so – I talked about that in our call that I could see us growing inventory, at least our goal is to grow inventory a few million dollars this quarter and I think we will do that.

Again, we are very, very focused. Getting out, and it will be couple of months worth of inventory having on the shelf. So that we do have the ability to handle permutations in the forecast, because this isn’t a 100% forecast accuracy by product, by customer, because it is hard to see always where some of that price are coming.

Having said that, I mean, you still – in the new products you are always behind a little bit because the demand for new products is very high and there was isn’t a time to ramp up.

So, our goal is to have as little as possible in backlog. Most quarters we have had very little backlog coming out of the quarter, which means every quarter we start from zero. In terms of – not from a pipeline point of view but from a backlog point of view, we did have quite a bit of backlog this past quarter and it’s probably I think, – I can think of one or two other quarters that I have been at the company where we also got into that kind of a situation.

Brent Thill

I know there is a lot of new faces to the story, but maybe just from an architectural prospective, you could just give us your 40,000 (inaudible). CheckPoint has taken a completely different architectural perspective than you have with the ASIC processor. What’s the advantage at a real high level for you versus what some of the competitors are doing here?

Ken Goldman

Well, I think, if I look at how we think about what we do is the fact that we have everything under one roof really does help us a lot. And so, whether it is the operating system, whether it is the hardware architecture, the FortiGuard descriptions and the threat management which we have and some other companies outsource that, we hit all the various certifications. We do use standard products, standard processors, we do use Intel processors. In addition to that, we have a network ASIC processor; we have a content ASIC processor. I have now seen some of our competitors also now introduced ASICs.

And so, we do believe – first of all it has been proven we bring those products out every two to two and half years, it gives us a competitive advantage in terms of capability. And the fact that we were able to move really quickly on our feet by having an integrated approach to address this market has been very, very helpful to us. And effectively we created the UTM space, it is the way we were able to handle all the various capabilities, in terms of the capabilities under the UTM umbrella, by having the integrated approach and so. I have not seen – again, we are not going to duplicate, where products are out there, we are not going to duplicate, obviously, Intel processors and other standard components. And so, we use products from a number of component suppliers, but we do find in terms of adding speed and capability, particularly performance that the two ASICs in particular allow us to better support the market.

And honestly, I think as I look at the world, I think you find more companies coming our way than the other way.

Brent Thill

Last question. You had really good growth this year, accelerating revenue growth, and your margins actually gone up as well. Can you give us a sense of how you are balancing the growth with margin? We don’t see a lot of good growth stories right now that have operating margin expansion and so.

Ken Goldman

If I look at the overall margins, I sort of think about this a little bit, the – last year for the first three quarters we did 18% operating margin, this is all non-GAAP. We did 20% for all of ’10, and this year to date I think we are around 24%. And that’s all come from operating expenses, operating expenses as a percent of revenue down about 4 points in ’11 versus ’10. Some of that is actually by design, I mean, we clearly have moved to get more efficiency in sales, and so you are seeing sales and marketing close to 30% of revenues as opposed to 32%, 33%, 34%.

We have done a good job in my opinion in terms of managing R&D expenses, I am sorry managing G&A expenses. R&D expenses actually, we would like to invest faster, it is always a challenge for us to find the right people that have the right capability and expertise. And so that scenario that honestly is probably a little below where we would like it to be. I always say, I sort of having been in a number of industries, I sort of liked the neighbourhood we are in. By that I mean, by and large the companies in our space do make very good profitability. I look with envy honestly at CheckPoint and their operating margins. And it just shows you what the opportunity is in this industry, I think even with whatever ills they may have, I think folks like Cisco are still making good money in this space. And so, this is an environment where you are able to make good profits.

Having said that and I think I said just a little bit on our call last quarter, we are clearly above the model we have staked out. As I look into ’12, I mean, to the extent that we can, we wanted to put the accelerator on in growth and so we will be focusing on growth. And so, for at least for right now, I would be more than pleased if we just held our margins, never mind margin improvement – margin improvement has tended to come when we over achieve revenue or under spend, as opposed to being consciousness objective.

Brent Thill

Questions? We always have some questions out here.

Ken Goldman

Either way you have to call on people.

Unidentified Analyst

I don’t know if this was treasured [ph] on, but some customers that might be using your product just for firewall or someone that have lower kind of recurring revenues attached to them. What do you see the long-term trend in that being?

Ken Goldman

Let me get the question right is more customers potentially are using a product as a firewall, is that way the percentage of services have gone down a little bit? Is that it? Okay.

These are bright things that I looked at for the last quarter, I mean, that really drives our billings and the transposition of those into revenues. First of all, there is one thing that has fundamentally changed, which is new revenue records [ph], as you know, we do a pre and post on that this year, which we will be happy to do next year. And we have achieved about, anywhere from 3.5 million to 5.0 million more accounted [ph] revenues, this quarter that perhaps we would not have been able to recognize as revenues upfront, previously. That’s most evident in China, which we had ratablized [ph] all the revenues there before. Now that’s for the most part recognized upfront. China is an area where the product is used with less services, they don’t require 24/7. So for so, it is a case where clearly more of the revenues recognize upfront, whereas before all of that revenue would have been ratablized [ph].

I think, in terms of last quarter, we did see a little bit higher ratio of hardware billings to services billings, part of that is timing honestly. We see in Q4 a higher percentage, if you will of renewals, significantly more opportunity for renewals in Q4 than Q3 because a lot of accounts that go terminus at the end of the year, so that will give us an opportunity to see more service revenues. And then in terms of the hardware related billings, it is correct to say we did have a little higher percentage there, in terms of non-bundled hardware versus bundled hardware, maybe 2 or 3 or 4% more than we have had in the past. And part of that is where some people may use it more as a pure firewall than what the bundle services, a bundle of UTM.

I am not sure that’s all bad. I mean, as I said, as I look at the firewall business it is certainly growing, there is a lot of activity there, there is other critical people are making a lot of hub about them in the market, and I think we have to see how we can even better penetrate. We have the products that compete, but the real questions is how well we go out and compete and position the company with specific products that are really aimed for that market, but that is the case that has occurred.

Brent Thill

Great. We need to wrap up. Thank you Ken and just a reminder at 2:00 we have our IT panel, next door, so we will have our Global CIO who spends a lot of money and you will be able to ask her what she is spending it on. So, you won’t want to miss that. Thank you.

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