Fortinet's (FTNT) CEO Ken Xie on Q4 2015 Results - Earnings Call Transcript

| About: Fortinet, Inc. (FTNT)

Fortinet, Inc. (NASDAQ:FTNT)

Q4 2015 Earnings Conference Call

January 28, 2016 16:30 ET

Executives

Michelle Spolver - VP, Corporate Communications and IR

Ken Xie - Founder, Chairman and CEO

Drew Del Matto - CFO

Analysts

Sterling Auty - JPMorgan

Michael Turits - Raymond James

Shaul Eyal - Oppenheimer

Gray Powell - Wells Fargo

Saket Kalla - Barclays Capital

Brent Thill - UBS

Jim Fish - Citi

Scott Zeller - Needham

Erik Suppiger - JMP Securities

Operator

Welcome to the Fortinet Q4 2015 Earnings Announcement Conference Call. [Operator Instructions]. As a reminder, this call is being recorded. I would now like to turn the conference over to Michelle Spolver. Please go ahead.

Michelle Spolver

Thank you, Sabrina and thank you everybody for joining the call today. Good afternoon. This conference call is to discuss Fortinet's financial results for the fourth quarter and full year 2015. With me today are Ken Xie, Fortinet's Founder, Chairman and CEO; and Drew Del Matto, our CFO. As for the structure of the call, Ken will begin by providing perspective on our business and product advantages. Drew will then review our financial and operating results with our forward guidance outlook before opening up the call for questions.

As a reminder, today we're holding two calls. For those who have additional or more detailed questions, we will hold a second call at 3:30 PM Pacific time. Both calls will be webcast from our Investor Relations website.

Before we begin, let me first read this disclaimer. Please note some 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 in our forms 10-K and our most recent 10-Q for more information. All forward-looking statements reflect our opinions only as of the date of this presentation or call 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 the earnings press release and also on slides 13 and 14 of the presentation that accompanies today's remarks.

Please refer to our 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 prepared 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 Ken.

Ken Xie

Okay. Thanks, Michelle and thanks for everyone on the call today to discuss our fourth-quarter and FY '15 result. I'm pleased to share that we have a solid fourth quarter, driven by 35% year-over-year growth in billings.

We continue to gain market share, growing more than 3 times of the network secured market one billion dollar scale. We're succeeding in landing important new customers, expanding within our leasing base of more than 250,000 customers and innovating and delivering the best products in the industry. The internal segmentation trend that we first identified in 2014 is playing our nicely around the world. Fortinet's strong advantage on both performance and feature is driving the growth in our business. This is evidenced by the strong sales of high-end FortiGate system during the first quarter which accounted for 42% of our total FortiGate billings.

We continue to see healthy enterprise demand globally for high-end Fortigate appliances deployed as internal segmentation firewall to help protect the key network resource from attacks that get past premature defense or originally from within. The very high performance that is required for the internal firewall deployment is something Fortinet offers better than anyone else. And the ability to deploy our solutions in a transparent or switch mode to enhance, not disrupt existing network architecture has enabled an expansion opportunity within our installation base and has also opened doors for new customers.

Since Fortinet's start, our exceptional technology has been a differentiator that has helped fuel our success. No other vendor can deliver the broad, integrated security functionality and exceptional performance we have achieved with our FortiASIC, hold as many product certifications or offer such a comprehensive portfolio of security products.

As seen on slide 3, Fortinet's platform delivers intelligent security inside a network at an age and end point to enable similar security across our entire tech service from client to the core network to the cloud. Most other vendors only have pieces of the platform which leave open holes and makes security too complex to manage. Expanding beyond our core FortiGate deployment and selling our complementary products is one of our largest growth opportunities to address the more than $20 billion total addressable market. We're winning with a platform approach and during the fourth quarter closed several large deals around the world that included a mix of four or more Fortinet products including FortiGate, FortiSandbox, FortiMail, FortiWeb, FortiClient, FortiAP and others.

This platform approach is so helping us address advanced threats better than any other vendor. As a result, we saw another quarter of very strong growth in sales of our FortiSandbox client and cloud service.

Beyond just the ATP solution, Fortinet has a significant advantage in our ability to offer a comprehensive ATP framework that integrates FortiSandbox with our FortiGate next generation of firewall; FortiMail, email security; FortiWeb, application firewall; and FortiClient, end point product with our world-class research team to detect, correlate and stop zerodase threat and parameter e-mail, Web and end point. This provide customers with reduced complexity and a true integration between multiple protection systems.

On the ATP front, we're not just expanding within existing accounts, we're also landing new deals lead by FortiSandbox and other advanced technology products. In Q4, some of this included a [indiscernible] end point APT competitive win with a large regional community health organization in the U.S. who chose FortiSandbox and FortiClient solutions. We also landed a deal with a service firm in Europe and an employment service company in the U.S. that chose FortiSandbox with FortiMail product for advanced protection of the network and e-mail traffic.

Though it is still early in the adoption cycle, we also continue to see the traction of our product in the virtue and COG-based environment. As seen on slide 4, Fortinet has technology and product partnership with all major cloud platform providers.

During the fourth quarter, a few of the cloud deal including two U.S. enterprise software companies select the Fortinet virtual firewall to run on the new cloud platform. And that deal with European government agency to secure their copy righted space infrastructure. Looking ahead, I am especially excited about a new product. We begin a new product cycle with the release of our FortiASIC process line that will further differentiate us from competitors and meet customers increasing requirements.

In CP9, computationally intensive intrusion prevention, asset inspection and virtual private networking are uploaded to the ASIC to speed up processing and help eliminate network performance bottleneck. With CP9, Fortinet will once again raise the bar to deliver the industry's finest security performance. Over the next few years, we're refreshing our entire line of mid-range, enterprise and acaricross [ph] Fortigate system to continuously extend our product and technology lead.

Also early today, we announced our 40 OS 5.4 operation system which bring many exciting new features to our FortiGate appliance. Advanced management computation, improved analytics and our swift one-click action in 40 OS 5.4 make it easier to implement an operationalize the internal segmentation firewall, advanced to add protection and secure excess control.

40 OS 5.4 also brings advanced security for protecting mobile device and applications. With a broad integrated feature, highest performance and a strong position in the carrier network, Fortinet has a strong competitive advantage here in our ability to provide content application and user security in the mobile environment.

A few weeks ago, we held our annual global partner conference and I'm pleased to share that enthusiasm for Fortinet is highest ever as we shared with partners Fortinet's product plan and sales strategy. We're now a $1 billion-plus company selling to and supporting the largest corporation and government entity in the world.

To better align with our scope and scale, we have unified our sales force under one global structure led by Patrice Perche, Executive Vice President of Global Sales and Support. Patrice has been with Fortinet for almost 12 years and has done a truly exceptional job of leading and growing our business in EMEA and APAC where we're the number one network security company in many countries. He brings his best practice in sales and operation to our entire global sales force going forward.

Fortinet has a clear technology advantage and a strong innovative road map in place to help us continue to grow our market position and address a huge market opportunity. From the start, our vision was to deliver broad, truly integrated high-performance security across the IT infrastructure.

We're seeing it play out in the market now and we're well positioned to continue to succeed. I will now turn the call to Drew to review our financial results for Q4 and FY '15, as well as outlook for the first quarter of 2016.

Drew Del Matto

Thank you, Ken. Fortinet ended our 2015 fiscal year strong with billings, revenue and EPS meeting or exceeding our guidance. We're particularly pleased with our billings growth of 35% which is above our guided range. As Ken mentioned, we continue to grow roughly 3 times faster than the network security market and Fortinet is one of very few companies with over a $1 billion run rate that is achieving this level of impressive growth. It's noteworthy that we're also maintaining profitability, adding new customers and generating significant free cash flow.

During Q4, we continued to execute on our strategy of acquiring first seats at tables and landing several marquis deals at some of the largest, most well-known enterprises in the world. These customers, as well as those we've added in recent quarters have vast infrastructures and provide abundant expansion opportunities for Fortinet in the future. We continue to see our land and expand opportunity play out during the quarter, highlighted by several large expansion deals from enterprise customers acquired as recently as two quarters ago.

I've spoken about the lifetime value of our customers and shared that a new customer that spent $1 with us in the first year ultimately spent over $5 with us over a five-year period based on our 2009 cohort through 2014 I'm happy to report CLV has risen to more than 6.5 for the same cohort for 2015. We have far more enterprise customers today than we had in 2009, providing a fertile opportunity to grow our CLV with expansion deals.

Not only does this expansion give us confidence in future growth for years to come. It will also be a driver of leverage in our operating model over time, as it costs less to expand within a customer than it does to land one. We're very pleased with this achievement.

Now let me share our financial results for the fourth quarter which can be seen on slide 5. As I just mentioned, Fortinet's billings increased 35% year over year to $381 million, exceeding our guided range of $364 million to $369 million.

Total revenue of $297 million was up 32% year over year and above the midpoint of our guided range of $293 million to $298 million. Our deferred revenue balance increased to $791 million, up 42% year over year, exceeding our billings growth of 35% and illustrating our ability to sell more subscriptions and services.

From a profitability perspective, non-GAAP operating margin was 16% and non-GAAP earnings per share was $0.18, consistent with our guidance. In accordance with our communicated plan, we continued to invest in line with our strategy to drive growth. Higher gross margin of 74% was driven by higher-value subscription bundles which drove growth in this valuable, margin-rich recurring revenue stream.

Finally, our cash generation is substantial and growing as evidenced by the $60 million of free cash flow generated during the quarter, up 101% from last year. This continues to demonstrate Fortinet's ability to generate a significant amount of cash while investing for future growth. Our fourth-quarter guidance included the contribution from our Meru Networks acquisition. Sales from the former Meru contributed $16.5 million in billings and $16 million in revenue during Q4.

Our new secure enterprise Wi-Fi product line which incorporates our best of breed security with Wi-Fi technology we acquired from Meru, is slated to be announced in the first half of this year. With the integration nearly completed, including a fully combined sales team, integrated price book and sales funnel, along with systems and operational processes, we will not break out Meru sales going beyond Q4 2015.

Our quarterly performance continued to reflect a healthy security market as the number and sophistication of network security threats continued to grow. This is illustrated by various high-profile attacks that have occurred recently, some of which made headlines and many that did not.

The cost of cybercrime is estimated to be up to $1 trillion or approximately 1% of global GDP. Cyber security related job postings have recently grown 3 times faster than overall IT job postings which is a positive future indicator for growth and change.

Cybercrimes will continue to increase in sophistication and cost. We expect this trend to bring a greater focus on corporate responsibility and increasing accountability to protect information.

As a result, security remains a critical IT investment priority. As Ken stated, companies are demanding a proven best in class integrated cyber security platform like Fortinet's rather than disparate point solutions that are costly and less secure. In Q4, we added approximately 9,000 new customers to our base of more than 250,000 customers.

A few deals landed with new customers included a first seat at the table of a Fortune top 5 company that is one of the largest brands in the world. This was an expansive firewall refresh project and the customer wanted a more feature-rich, integrated security solution that would allow them to consolidate multiple disparate point products onto a single platform. They chose Fortinet over the incumbent competitor for the strength and breadth of our integrated cyber security platform and ability to scale to support future growth.

We also landed a deal with a major household global consumer brand clothing company that chose Fortinet for a large branch to core deployment based on our unique ability to provide an integrated security and wireless access platform that included our FortiGate, FortiSwitch and FortiAP products. We continue to acquire first seats at very large tables and are also winning substantial expansion deals due to the strength and performance of our integrated cyber security platform.

In Q4, we expanded in numerous large enterprise accounts. Some of these were landed as recently as just two quarters ago, demonstrating that our investment strategy is paying off. A few of the many expansion deals closed during Q4 included a data center firewall deal with one of the largest banks in the world. We landed a first seat at this table in Q2 for a large internal segmentation firewall deal.

In Q4, we landed another important seat via a new deal and strengthened our strategic position in this account. We also expanded within one of the most recognized European auto makers in the world that upgraded and expanded its Fortinet deployment with the purchase of numerous additional next-generation firewalls and services.

Our service provider business around the world was also very strong during the quarter. This was in large part driven by technology upgrades for cloud-based security offerings and new MSFP offerings. Fortinet is the partner of choice for nearly every major service provider in the world. This is due to the fact that we provide the highest levels of performance, security and advanced networking as well as superior deployment flexibility. This combination allows them to offer an array of services including fully hosted managed security, private hosted cloud or customer premise based services.

Some large wins during this quarter included seven-figure expansion deals with several U.S. and international service providers that upgraded and expanding their large Fortinet deployments to deliver new cloud-based managed security services to support growing subscriber bases. As Ken mentioned, we continued to see a high level of interest in our internal network segmentation firewalls which are highly differentiated from competitors in terms of security, performance and ease of deployment.

Sales of our FortiSandbox ATP appliances also continued to grow in all three geographies, with total billings more than quadrupling year over year. The integration of FortiSandbox with our firewalls, e-mail appliances and web security appliances delivered an advanced threat prevention framework that no other security vendor could offer. We also continued to see nice growth in sales of our secure Wi-Fi appliances as well as our FortiClient end point software products.

Finally, I'd like to highlight that we had numerous large subscription and support renewal deals with existing Fortinet customers. Our renewal rates which are tracked by appliances, not customers, remain in the mid-70% range and exclude product refresh and upgrade purchases. Our customer retention rate continues to be above 90% which demonstrates overall customer satisfaction as well as the stickiness of our solutions. Our high renewal and retention rates also show that we're not only winning numerous customers from incumbents, but we're keeping them.

During Q4, the number of large deals grew in all categories. Deals over $100,000 grew 50%, deals over $250,000 grew 41% and deals over $1 million also grew in both number and size of deals. Our breakdown of billings across our top five verticals was service provider at 26%, government at 13%, financial services at 10%, education at 7% and retail at 7%.

Now let me turn to the geographic breakdown of billings for Q4 which had strong year-on-year, year-over-year growth across all regions. Americas billings grew 33%, EMEA billings grew 40% and APAC billings grew 30%.

The Americas had another solid quarter, especially given the continued economic headwind from Canada. Also recent investments in sales and marketing are still ramping. We're still focusing on market awareness, lead generation and sales enablement in the Americas, led by our CMO who started in September 2015. Fortinet is truly a global portfolio business, diverse in both geographic and market scope. We've grown well across all regions and segments, including the service provider, SMP, SMB and enterprise markets.

Seeing an opportunity in the U.S. enterprise market where we were underpenetrated, we began investing and targeting this market about two years ago. In that time, this business grew 77%. We've also landed some of the largest and most important logos in the world. We focused on and talked about our U.S. enterprise business as the higher-end segment of the enterprise versus the less discussed but much broader mid-market enterprise.

We've succeeded in acquiring many large enterprises, but there have been some challenges including long sales cycles which we again faced in the fourth quarter. As a result, our high-end U.S. enterprise team grew billings 15% year over year as we continued to be affected by the size and timing of specific deals with customers in the top end of the enterprise market. We believe growing in the broader mid-market enterprise would help provide more consistent enterprise growth in addition to expanding our market opportunity.

Turning to international performance, EMEA delivered another exceptional quarter, growing an impressive 40% year over year. We delivered strong results across all sub regions, especially the UK and Middle East. Return on investments and upgrading our sales force and reseller channel continued to yield growth and expansion.

In APAC, we grew 30% year over year and saw strong performance in Japan, Southeast Asia and Australia. We're also seeing returns in APAC in our sales and marketing investments. Before moving on to the breakdown of our products, I want to elaborate on the positive changes we're making to enhance our sales structure. We're excited about the evolution of our global sales model under Patrice Perche's leadership, as Ken noted earlier.

Our teams are already up and running. Our newly globally structured sales force enables us to better source, win and support multi-national enterprises more effectively. As our sales force integrates to attack the large multi-nationals, the former U.S. enterprise team has been redistributed to focus on either large global strategic accounts or regional territories. The U.S. enterprise metric we have been providing was based on sales team alignment. That specific team no longer exists with our global strategic account and regional models. As such, the U.S. enterprise metric will no longer be applicable.

We will utilize data on product billings mix, large deals and key wins as metrics to gauge the success of our global enterprise investment strategy. Our geographical and top side vertical reporting is also useful in understanding our various market trends. Now turning to billings by product segment on slide 6, we continued to see diversity of product billings across all segments. Our high-end FortiGate products accounted for 42% of total product billings, up both sequentially and year over year. This indicates strong sales to service providers and large enterprises. Our mid-range enterprise products accounted for 26% of the total mix and our entry level products accounted for 32%.

Total revenue was $297 million during the fourth quarter, up 32% year over year and at the high end of our guided range. Revenue performance was driven by the combination of 31% year-over-year product revenue growth and 34% year-over-year services revenue growth.

On a geographic basis, you can see on slides 7 and 8 that revenue continued to be diversified globally which remains a key strength of our business. In the Americas, revenues grew 33% to $122 million. EMEA revenues grew 35% to $115 million and APAC revenues grew 26% to $59 million.

Moving to non-GAAP expenses and profitability, during the fourth quarter, our non-GAAP gross profit margin was 74%, above our guided range of 70% to 72%. Non-GAAP product gross margin was 63% Non-GAAP service gross margin was 84%, highlighting the margin expansion opportunity of our FortiGuard and FortiCare subscription offerings which are also recurring revenue streams. Non-GAAP gross margin was positively impacted by higher sales of software products such as our VM line of virtualized security solutions and the impact of recent price increases to our FortiGuard security subscription bundles.

Non-GAAP operating expenses were $171 million during the fourth quarter, resulting in non-GAAP operating income of $48 million or 16% of total revenue. Non-GAAP net income for the fourth quarter was $32 million or $0.18 per share based on 177 million diluted shares outstanding. The non-GAAP tax rate for 2015 was 34%. A reconciliation of non-GAAP and GAAP financials can be seen on slides 12 through 15.

As seen on slide 8, we ended Q4 with a strong balance sheet including $1.164 billion in cash and investments. Our $60 million of free cash flow was primarily offset by $60 million of share repurchases. As previously mentioned, free cash flow increased in the fourth quarter by 101% year over year. This includes a $9 million benefit received in a favorable litigation settlement in December.

Our continued strong cash flow reflects our ability to invest in the company to support growth while also generating substantial free cash flow. Annualized inventory turns for Q4 were 2.3, in line with our annualized goal of 2 or better. Our deferred revenue balance increased $791 million, up $233 million or 42% year over year and $84 million sequentially. Finally, during the fourth quarter, we repurchased approximately 1.76 million common shares for approximately $60 million at an average price of $34.12. As of the end of December, we've repurchased approximately 5.5 million shares for a total of approximately $137.5 million at an average price of $24.84 under the $200 million stock repurchase program that began in December of 2013.

This plan expired on December 31, 2015. However, earlier today we announced that our Board of Directors approved a new $200 million share repurchase plan that will extend through December 31, 2017.

Before discussing forward guidance, let me wrap up by quickly running through some summary level financial results for the full year 2015 as shown on slide 10. Billings for 2015 were $1.232 billion, up 37% year over year and more than triple the growth rate of the network security market. Revenue for 2015 was $1.009 million, up 31% year over year. Deferred revenue grew $232 million, up 42% year over year.

Non-GAAP gross margin was 73% and contributed to non-GAAP operating income of $133 million or 13.2% of revenue. Non-GAAP diluted net income per share was $0.51 for the year based on 176 million shares. And free cash flow increased 49% year over year to $245 million or 24% of revenue, up from 21% in 2014.

Now, let me finish with our guidance for both the first quarter and full year 2016. As a reminder, all forward-looking statements including all of the guidance statements provided are subject to Michelle's cautions at the start of this call.

Fortinet's market opportunity and technology advantage is significant and our investments have helped lay the foundation for our future growth and increasing profitability as we continue to scale Fortinet to be a multi-billion-dollar business. We've more than doubled our annual growth rate over the past two years and continued to take market share and grow more than 3 times the industry growth rate.

Market signals and discussions with customers point to a continued healthy security market, but continued uncertainty in the global economy could potentially impact our business. Additionally, our recent sales organization changes that we believe will greatly benefit us in the long term may cause minor disruption in the short term. For these reasons, we're approaching Q1 and 2016 with cautious optimism.

During Q1, we expect billings to be in the range of $315 million to $322 million, up approximately 25% year over year at the midpoint. Total revenue is expected to be in the range of $270 million to $275 million, up 28% year over year at the midpoint.

Non-GAAP gross margin is expected to be approximately 72% to 73%. Non-GAAP operating margin is expected to be approximately 8% to 9%, reflecting typical seasonality in our Q1 operating expenses which include higher benefit and payroll costs. And, finally we expect non-GAAP earnings per share to be approximately $0.08 to $0.09 based on an expected diluted share count in the range of 179 million to 181 million fully diluted shares.

For the full year 2016, while it is still early in the year, we expect billings to be in the range of $1.505 billion to 1.52 billion, up 23% year over year at the midpoint. We expect total revenue to be in the range of $1.25 billion to $1.26 billion, up 24% year over year at the midpoint.

Non-GAAP gross margin is expected to be approximately 73%. Non-GAAP operating margin is expected to be approximately 15%. Our investments in the business have laid the groundwork for future growth and profitability. We believe, going forward, we can show consistent operating margin expansion of approximately 1% per year towards our target model of 20% or better exiting 2020.

We expect to do this mainly through increased sales productivity and return on marketing investments as well as through the benefits of expanding with our current and future base of customers. We believe we could achieve this level of margin expansion while still investing for share gains and future growth. Finally, we expect non-GAAP earnings per share to be in the range of approximately $0.67 to $0.69 per share based on an expected diluted share count in the range of 183 million to 185 million fully diluted shares.

In closing, I'd like 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.

Question-and-Answer Session

Operator

[Operator Instructions]. Our first question comes from the line of Sterling Auty of JPMorgan. Your line is now open.

Sterling Auty

Let's go ahead and hit it right on the metric, the 15% growth in the high-end of the U.S. enterprise, you still showed, you know, I think 29% organic growth in billings and obviously better reported billings. So I guess the question is, that high-end enterprise, does that include or exclude service provider which is then probably a stronger point for you and even though that metric is going away, do you still think there is opportunity for improvement in the growth in that segment?

Ken Xie

Sure, sterling, it does not include any carrier business in at a time enterprise number, so that's point one. We do see opportunity there, you know, we believe, you know, we have been really working at the top end of the business as we talked about. We believe, you know, with the marketing investments we're making on market awareness, lead generation and enablement and as well as just increased productivity of the sales investments in the Americas will pay off over time. There is really a broad market we don't believe we've tapped, so to speak or penetrated and that is the broader mid-market and that is the idea as we go to a more regional alignment, if you will.

Sterling Auty

And then in terms - one follow-up question would be, you guys have been the strongest vendor in the mid-market in terms of your origin and then you came up into the service provider. You talked last quarter about I guess solidifying your position with increased investments for 2016 in the core where you have been strongest. Any highlight of what the investment philosophy for 2016 to do that would be?

Michelle Spolver

Sterling, it is Michelle. I will correct that because I think the perception of Fortinet through the years, when we talked about enterprise, is that we're strong in the mid-market. And that wasn't necessarily true. We're strong in enterprises internationally which there is a lot of mid-market enterprises internationally in the U.S. ours was in the carrier and the SMB space. When we addressed enterprise a lot of that was at the top end. We have been able to grow and do more of that in the last two years. We were doing some business in mid-market but that wasn't our strongest area. It is something that was a misperception put out by Fortinet but it wasn't actually true. The opportunity, we see an opportunity across the enterprise.

Drew Del Matto

I mean, Sterling, look, I believe what we have been saying is that when we made the investment, when we hired sales people and probably didn't make as much marketing investments as we made recently the sales people, the migrate toward the top end. That is where the big deals are, right? As they do that, that worked really well. We took down some very impressive logos and expanded those. I think we shared a lot of those stats. I think that part is very impressive. The other part we're sort of coming down from the carrier space if you will to that end of the market. We were coming up from the SMB space. I think that a more market driven motion. That is the adjustment we're trying to make going forward.

Ken Xie

We were very successfully internationally both on the enterprise SMB that is where bring some of the practice international make it a more global structure will also help in growing enterprise.

Operator

Our next question comes from the line of Michael Turits of Raymond James. Your line is now open.

Michael Turits

I am pleased to see margins will be up and really like that you're now talking about a steady ramp of margins. After last quarters are [indiscernible], can you be specific as possible where you get the switch over getting leverage this year and how that is going to be sustainable?

Ken Xie

We have the technology like I mentioned, to enable us to have like a better rich feature and at the same time like a performance compared to competitor. So that give us keep expanding and keeping improving the margin there. And also there is a new opportunity like I said is the internal segmentation firewall that is expanding beyond the traditional firewall. That is mostly in the high-end high speed environment. That is also helping the margins.

Drew Del Matto

You know, first of all, you're probably - I do think you're seeing a shift of higher margin shifts and even software in there and those generate higher margins. It is cheaper to land and expand. And if you look at the people that we've had - sorry, I had that backwards. Cheaper to expand and land definitely or more efficiency to expand the land. The other piece of it is that we made a lot of headcount especially in the U.S. and we think we could see productivity gains there with marketing and also some returns on those investments as well. Those investments, you know, really have been made. You know, we will continue to make some investments but you know we will be able to moderate those based on the opportunities we see and the level of growth we see.

You know, all of that - you know what we've seen also, one of the reasons we focus on the customer lifetime value statistic, it proves out the model, the more of these accounts you acquire, the revenue rich and higher end opportunities, you do have an opportunity to expand, we're very focused on the margin within those accounts and managing that so that we do provide that return and show that in the P&L. You know, just a couple of other points I'd make, we merged with - or we acquired Meru, really in, you know, second week of July I think roughly. And during that time we were, you know, we managed through about $13 million of dilution and we just carried that over.

We made some adjustments and we feel pretty confident when we want to make adjustments we can make those adjustments and that gives us a bit of a tail wind in thought here so to speak. And we will scale the other areas G&A and legal. There is room to scale those. And, you know, you make it a point out of those longer term. But we do see leverage in the model. It is primarily on the sales and marketing line. Get a little bit hopefully a point from the gross margin longer term as you shift into higher margin recurring revenue stream.

Michael Turits

I got a follow-up, I was going to ask a standard question a lot of us have been asking. Do you see a change in the qualitative spending margin to something diversified or urgent away from that security spend?

Drew Del Matto

I think some of the legal enterprise take a little bit longer trying to make a decision. And but overall security is still very important for the business there, for on line there. So we don't see much slowdown overall but some bigger decision may be more careful to make some decision.

Ken Xie

You know, I think, Michael, maybe one way to think about it is there has been a lot of change in organizations. We wanted to point out the growth in cyber security related job postings related to IT job postings as a whole. The number is three or even north of that. So I think that brings change in organizations. If you look at the last couple of years, perhaps there was buying a lot of firewalls and people catching up, so to speak. As you look forward it becomes more strategic. You bring these new people in and you think they think more strategically. And the key here is the cyber security platform.

The ability to integrate APT framework through the network, into the end point, I think is critical. And to do that organically so that it really all works together seamlessly is what we uniquely provide. We do view that as tremendous opportunity. As Ken said, we have been talking about internal segmentation firewall, we do that with the highest level form man's, best ease of deployment and feel like we really are superior versus the competition. Those are the types of strategic opportunities customers are looking for and I think we shared some of those examples.

Ken Xie

And also some of the point solution we see year goes to the high-end of customer also have this advantage of some of the integrated solution like whether the platform because enterprise consider what is the cost to manage total security infrastructure, so that's more advantage for the integrated solution or solution compared to a point solution. Traditionally only the very high-end customer can afford for some point solution, manage each of the point solution [indiscernible] goes away.

Operator

Your next question comes from the line of Melissa Gorham of Morgan Stanley. Your line is now open.

Unidentified Analyst

This is actually Tom Mao [ph] calling in for Melissa. In terms of ASP increases how do you think that has impacted this quarter's results and how exactly do you expect that to flow through 2016?

Drew Del Matto

Sure, Tom. You know, it has an impact. I think what you do is you see a higher mix of services. It is interesting on the revenue line I think the mix of, I think it is 51% services to 49 product is not out of line kind of with history. When you look at the billings, I think it is more weighted to the services side, as well. And even some software. You know, one other thing I would point out, we have been seeing higher sales of software which is a good thing, higher margin. And some of that actually ends up on the services line as well because it is a rateable accounting or rateable accounting recognition.

To answer your question, definitely more of a shift in the bundles, one of the things we're also doing, you know, we've announced an enterprise bundle which is an even higher price point than the UTM bundle, you know, where we did the price increase a year ago. And that includes advanced protection and end point security as well. And, you know, that's really just coming up to speed now. And so we're purposely pointing that way because, again and that is a higher margin.

Unidentified Analyst

Just to quickly follow up on that. You talked a lot about how you're seeing high demand for the internal firewalls, is that a meaningful business today? And does the capability offered in the new operating system, you know, expect to meaningfully accelerate that?

Ken Xie

This is Ken. I think it is very meaning for a lot of enterprise, because like I say nowadays the traditional only protect the parameter, with all the mobility, agent based, using the compromise the mobile device. So that's where we see the market. We started to see two years ago the internal firewall. Traditionally internal is all were open, switch ticketing together. So we see it is a huge market. We don't have the data from the leading research firm, yet, but my estimate for the enterprise that is probably the same market or even bigger long term as the traditional parameter of firewall.

Operator

Your next question comes from the line of Shaul Eyal of Oppenheimer. Your line is now open.

Shaul Eyal

Two quick questions on my end. Drew, on saving marketing, as you think of further think of sales force globally, will it be more U.S. focused or more European focused? You guys have done a phenomenal job in Europe and solid results in the U.S. How does it figure out between the breakout between the EMEA and U.S. or Americas.

Drew Del Matto

Secondly, the way we're thinking about it, is that we will continue to invest. And, you know, we're doing extremely well internationally and, again, that motivates us from the changes we're making in the leadership. Because that team is experienced. They have depth in our products. They have depth in our markets. They have really been successful in all of the SNB, not just the top end. We hope to mimic that or carry that over into the U.S. We've made a lot of sales and marketing investments in the U.S. We continue to make some. But personally we're really more focused on productivity at this point in the U.S. In realizing the investments we made there, maturing those.

And also, making sure the organization, giving the organizational changes take hold, that is how we think about the U.S. Broader international EMEA remains a great market for us. APJ we see some opportunities. The only cautionary factor I would throw out there right now is obviously there is some turmoil in world markets, you know, just the global economy and what's going on there. So we do have an ounce of caution in terms of that and I think we will be smart where we're investing in the face of that until we figure out what that means.

Shaul Eyal

In hindsight - what is the time frame it takes, sales guy or lady coming on board for Fortinet to become fully productive? Is it a quarter? Two quarters? Maybe even three quarters?

Drew Del Matto

Well, you know, I would say on average it is probably closer to - you know, it's slightly longer than six months, let's say. It is the bottom end of the market, more channel driven end. The sales cycle can be 90 days so it is really just kind of getting up to speed on the products and ramping up. It is never as easy as 90 day, right? You have to give people a month to kind of, you know, find their way around, so to speak. And then at the high-end if they're more focused on calling a large financial institution, that is an investment that can take a year or even two years. On balance, somewhere slightly more than six months is how we model it. I hope that helps.

Operator

Our next question comes from the line of Gray Powell of Wells Fargo. Your line is now open.

Gray Powell

Maybe a question on margins, we often get a lot of questions on the operating profile and investments you're making. If I look at free cash flow as a percentage of revenue it improved to 24% in 2015, that is up from 20% the last couple of years. As you make your way back to the longer goal of 20% operating margins, how much of that should flow through to free cash flow and can we see free cash flow margins getting back to 20% or maybe 30% range?

Drew Del Matto

I don't have a lot of guidance other than near-term, you know, CapEx guidance to give you on free cash flow. You know, I do - there is no plan to do anything with the free cash flow kind of out of our normal trend, though. It would just be more of the CapEx, I think, basically CapEx and, yes, real estate. I think near term we're finishing an ERP project this year and that will go away somewhere in the middle of the year.

Gray Powell

And maybe one follow-up, I think you mentioned the impact of Meru in the second half of the year. You said that was like 13 million of operating dilution? I just want to make sure I had the number correct.

Drew Del Matto

Yes, I think when we merged - the way it was modeled would suggest, you know, had we done nothing or what they were losing, the extrapolation was $13 million of dilution pretty much we did it through restructuring and best practices.

Operator

Our next question comes from the line of Saket Kalla of Barclays. Your line is now open.

Saket Kalla

So, first, for Ken or Drew, a lot to talk about the platform approach outside of FortiGate or outside of FortiGate. Can you remind us how the mix of billings has maybe evolved around FortiGate or non-FortiGate over the last couple of years.

Michelle Spolver

I mean, you're asking Ken and drew and Michelle is answering. But I don't have the numbers right in front of me. It is definitely growing. We called out some, you know, all of the products are growing. Some are growing more than others and called out a few that we've seen some good growth on. Some of those would be FortiMail, FortiSandbox, for sure. FortiDOS. And FortiAP. It is still now a non-material portion of our revenue but it's growing as our overall revenue is getting bigger as well. The other thing I think, too, is that - some of the subscriptions - subscription revenue that's coming in, in terms of billings, most of that applies to FortiGate. Some can apply to some of the other ones. Some don't have the FortiCard bundles attached to it.

Drew Del Matto

Yes, there is so much about the platform even if you're FortiGate. There was an earlier question about the importance of internal segmentation firewalls and I think it was a more tactical question to be frank. But from a strategic perspective, you're landing a feet by having that security. Even if you're selling the first FortiGate, at the end of the day you're really selling that platform because the opportunity for them to expand, you know, to APT, to the end point, to wireless, you know, that is the vision that we're selling. You know, again, we're certainly working on the marketing to make sure that message is out there. It does certainly work in the top end of the business - top end of the enterprise, that is where we have been very successful. You know, that story resonates at that level. Our goal is to ensure that resonates across all the business.

Saket Kalla

And just for my follow-up. Can you just recap the changes in the sales structure? I know we've got new leadership and, Drew, you said U.S. enterprises are getting split into multi-national and regional. But are there any other changes being made structurally and do you feel like you accounted from any other dis rip shun of the change in the guidance appropriately?

Ken Xie

This is Ken. No, we have one lead e global leader, for the sales and supporting compared in the past two parallel structure there. That is what help to improving the productivity and also to manage a lot of the bigger global account better. And also we defined the sum of the dot-com to be more efficient and also more local, locally handle some of the smaller compared to many layer in the past, mostly in the U.S. basically. So that's also we feel will be improving the productivity and that's the practice we use in the international in the past, but U.S. is a huge market, right? And then in the past we probably have quite some different layer. Now we try to make sure it is more addressed locally vision and at the same time global account will be addressed globally. That is under one leadership we have two different structure in the past.

Drew Del Matto

Just to add on to that, first of all, we absolutely have accounted for that in guidance. As we have the global economic condition, I think those are two obvious things that we need to account for and we believe we did. You know, the only other thing I would say adding on to Ken's comments, change is always a challenge. Any time you change leaders and organizations it is a challenge and it absolutely comes with the risk of disruption. I would say this, we've hired some very experienced professionals and the people we're bringing over, leadership change, Patrice and Holly, our CMO are working together very well. I think it all stems from the top. What I've seen to date in terms of strategy, execution, you know, the progress and their plan to make it, makes a lot of sense and they seem to be doing extremely well. And so, again, I think we have to have some level of caution to see how that takes hold. But I would say, you know, feels like we have the right people in place doing the right things getting to the right end.

Operator

Your next question comes from the line of Brent Thill of UBS

Brent Thill

Drew, just a follow-on the sales changes. I just want to be clear that that sales force reorg, the shape that you're talking about, putting the sales force in, that is now complete in January. That's behind you. You don't anticipate changes throughout Q1.

Drew Del Matto

It's pretty much behind, Brent. To be fair there is always - I think at the - the middle and top end of the sales organization that is always fair. There is always some adjustment it is more at the rep level or, you know, feet on the street level. Most of those are behind us at this point. I'm assuming your question was as of January 1. And there's been a lot that has happened. Mostly aligned up to that point and then there was a little bit I think left to go in the earlier part of January. But we're pretty much I think locked and loaded at this point.

Brent Thill

Okay. And when you talk about the mid-market initiatives and the things that you'd like to have there, if you had a couple things that you could wave your magic wand and appear in that mid-market initiative, what are the things that you think are important milestones that you would like to pass there, you know, whether, you know, it's you name the metric. I'm just curious what you think you need there to get it where you would like to see it.

Drew Del Matto

Sure. You know, first of all, I think the first thing you want to see is an uptick in awareness. And that is measurable. We have actively been measuring that. We have been very focused on awareness initiatives, if you will. Ooh I don't want to get too specific to give too much away to competitors, but we have been very focused there.

The second piece is funneled. Lot of this is lead gen. It helped build the funnel. That would be the second thing. And then ultimately what you're looking at here is productivity. We've made some investments in sales and marketing and, you know, specifically in the U.S. and, you know, I'm really focused on productivity at this point. So that's what I'm looking for. And the sooner I see that uptick, the better. I feel pretty good as it is, don't get me wrong but that is the indicator you look for.

Ken Xie

Also relatively new in the U.S. how to make them quickly and at the same time working mostly with part of the company structure.

Operator

Your next question comes from the line of Walter Pritchard of Citi. Your line is now open.

Jim Fish

It is actually Jim on for Walter. Drew, first can you discuss the transformation of the deals for the channel this past year versus when you started at the company including sort of where the mix is at between channel versus at this point?

Drew Del Matto

Well, everything goes through a channel. I think perhaps the way to answer the question is where are we doing more direct touch? And everything is in direct. Almost everything, probably a few things but business is primarily indirect, two tier distribution through distributor and value added reseller or similar type of partner. And so the where we're touching more directly is at the high-end of the business. A lot of as we talk about when the sales people came in, they focused more on the top end. Obviously, because that is where the opportunity-rich customers are. And so that where is they are and they are direct calling with sales engineers and, you know, in some cases large - fairly large teams to, you know, win in some of these larger accounts.

Jim Fish

And then my follow-up would be on the capital return why not go beyond the 200 million you announced given the cash you had especially domestically?

Drew Del Matto

Yes, we feel very comfortable with the 200 million. When we look at capital strategy we're very focused on first growth and that could be - we've clearly been investing organically in growth. And, you know, we're going to continues to do that but also inorganically those opportunities may or may not arise. We have nothing to mention on the horizon. Nothing specific to mention there but we're keeping our options open on that front as we continue to look for opportunities. And then we have been doing some buy back and you can look at the level we have been doing those. The $200 million gives us a nice window to do some of that. You know, were we GO to get aggressive we can do back for more, 200 million is what we did in the past. That number feels about right for now.

Operator

Your next question comes from the line of Scott Zeller of Needham. Your line is now open.

Scott Zeller

I wanted to ask about the recent headlines we've seen regarding Verizon and others selling data center assets. Can you tell us how that would impact your business and how material it might be selling into those data center assets? Just some color, please.

Drew Del Matto

We have a very strong position with a carrier on service provider and also you see the strong growth in last quarter also like I mentioned before how to secure mobile securities also key driver for behind because I feel best way to secure mobile go through service provider is traditional end point load lot of software in the device itself. For some carrier they may change the strategy like for the data center, but I don't feel they slow down the investment on the security mobile device and the other part of it and we still see as a strong growth opportunity in the care service provider space and data center I feel some application go to maybe specific company whether certain eCommerce or certain company they have a certain application maybe centralizing player but it is on the mobile security that's where we have the strong demand and keeping on the strong investment and that is also keeping driving the business there.

Scott Zeller

And then the performance in Asia is quite good. Any color specifically around China that you would like to share?

Drew Del Matto

We don't have a big business in China. We shared that in the business. We do some business there, but I would not at all call that a meaningful part of our business. You know, the issue with China is probably more the global economic conditions. You know, we thought - what we said a quarter ago was probably more emerging market commodity driven economies. But now they're just - we're a little more concerned just given that China, the situation may - we don't know obviously - but looks like it could be more serious than people thought three months ago and, you know, they have some big trading partners in Europe and across Asia. So that gives us a little - that's really where we would have more concern about China so to speak, outside of China, with the wake of what their economy could bring.

Ken Xie

Also, we have the technology product to have much better price performance function compared to others because the technology the problem solution. So the lower the total management cost. I think that's where in some downturn we have seen in 2008, 2009, that was a good opportunity to keeping gaining market share. So that's where we see this more as opportunity going forward.

Operator

Our next question comes from the line of Erik Suppiger of JMP Securities. Your line is now open.

Erik Suppiger

My first question is, some of your peers talked about the move to public cloud services like Office 365 as negatively impacting demand and the SMB in particular. Are you guys seeing SMBs move to the cloud in accelerated pace? If so, how is that impacting your low end business. In general it would be nice to hear how cloud is impacting your large business and mid-market as well?

Drew Del Matto

We have not seen the slowdown or changing of the SMB and also the CP device. But we also see strong growth in the virtualized cloud environment. We have the technology we can put a whole system into a single chip as you will see. That is actually driving a lot of strong growth in the branch office SMB, device. But on the other side, like we major cloud provider see some nice grow in there. And, like I said, we have end point, network side, application and to the cloud. That is where the five piece land up quite well together. So that is what we see all the five pieces kind of sell together, grow together, is advantage we have.

Erik Suppiger

I just had one follow judgment I just kind of wanted to touch on the global macro conditions. I think everyone is a little bit concerned over what's going on globally. You guys are reporting some pretty good strength in your international businesses. Can you talk about how you're viewing or how you're seeing economic conditions play out? Are you seeing any cracks at all? Can you walk us through the trouble areas, like South America, Russia and Canada, what you saw there?

Drew Del Matto

Yes, we didn't see a lot of issues, quite frankly we felt we had good quarters there. I would say our concerns are more forward focused we talked about with potentially China's you know any country or region that would have big exposure to trading with China. We didn't see it. I think part of it is the fact that, you know, we do have great products. I think our go to market motion internationally has been spot-on especially in EMEA. And, you know, I do attribute you know our success there very much to our team there and, you know, we feel - we feel like we could continue to do well there. Quite frankly, obviously the global economic condition is something we all want to watch and so we hopefully have, you know, taken appropriate caution there.

Ken Xie

Yes, also, like I said in my script, is that a lot of emerging market like I mentioned, APAC, we're already number one in the network security and keeping growth faster than our competitor because very strong product technology and strong with the right strategy. We're keeping growth faster than all other competitors. So that is where we bring some of the practice, the experience come from, from oversea to U.S. now and we also for improving our execution going forward to grow faster.

Operator

And our final question comes from the line of [indiscernible]. Your line is now open.

Unidentified Analyst

One question for Ken, in segmentation firewall which major competitors do you expect to see head to head and how quickly will pick up in 2016?

Ken Xie

Internal segmentation firewall mostly deployed as like the called switch mode, transparent mode, in an environment and will 10x to 100x faster than the traditional firewall. But most of the switching networking company don't have these security capability on the networking device switch and no router in there and traditional like security company which is software based is also have performance need and also how to deploy in the switch mode. So that’s where we don't see much competitor here and we see is an opportunity and we have huge advantage. So that's where we see is a - we have the best technology and timing to keeping investment grow in this space.

Unidentified Analyst

And follow up quickly the opportunity realized in 2016, whether it will be meaningful or would it be meaningful in the second half? How should we think about that?

Ken Xie

I think we identify this market two years ago and we keeping educated market in improving the product and both with ASIC and also the OS we announced today. Still a bit difficult to ask me how quickly the market growing, but from what I talked with the customer, long term they see especially in enterprise probably bigger than the traditional firewall market because nowadays they feel traditional way to deploy a few firewall is no longer secure enough so they need to move internally secure segment department different server but how quickly they adopt and how quickly they can maybe deploy where the company, deploy the switch, still difficult to say, but I think is that so far adopt pretty quick when the customer see the benefit they really like the approach given the actual protection.

Operator

I would now like to turn the conference back to Michelle Spolver for closing remarks.

Michelle Spolver

I just want to say thanks to everybody. We’re trying to keep our call shorter and so we did. This time we will have a second call at 3.30, so if you digest the information we gave you today, feel free to call back in at 3.30, happy to answer the remaining questions. That's it. Thank you very much.

Drew Del Matto

Thank you.

Operator

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program. You may all disconnect. Everyone, have a great day.

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