Fortinet (FTNT) Ken Xie on Q1 2016 Results - Earnings Call Transcript

| About: Fortinet, Inc. (FTNT)

Fortinet, Inc. (NASDAQ:FTNT)

Q1 2016 Earnings Call

April 26, 2016 6:30 pm ET

Executives

Michelle Spolver - VP-Corporate Communications & Investor Relations

Andrew H. Del Matto - Chief Financial Officer

Ken Xie - Founder, Chairman of the Board and Chief Executive Officer

Analysts

Jeremy Benatar - Raymond James & Associates, Inc.

Gregg Moskowitz - Cowen & Co. LLC

Saket Kalia - Barclays Capital, Inc.

Walter H. Pritchard - Citigroup Global Markets, Inc. (Broker)

Gabriela Borges - Goldman Sachs & Co.

Fatima Aslam Boolani - UBS Securities LLC

Melissa A. Gorham - Morgan Stanley & Co. LLC

Sterling Auty - JPMorgan Securities LLC

Catharine A. Trebnick - Dougherty & Co. LLC

Ken Talanian - Evercore ISI

Imtiaz Koujalgi - Deutsche Bank Securities, Inc.

Erik L. Suppiger - JMP Securities LLC

Rohit Chopra - The Buckingham Research Group, Inc.

Hendi Susanto - Gabelli & Company

Operator

Good day, ladies and gentlemen, and welcome to the Fortinet First Quarter 2016 Earnings Financial Analyst Q&A Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will be given at that time. As a reminder, today's program is being recorded.

I would now like to introduce your host for today's program Michelle Spolver. Please go ahead.

Michelle Spolver - VP-Corporate Communications & Investor Relations

Thanks, Jonathan. Hi, everyone again. Thanks for calling in. I have Ken Xie and Drew Del Matto with me here, and it's a full Q&A session, but I think before we launch into the first question, just a reminder that the Safe Harbor and cautionary statements that we made in our prior call affect any content that we deliver during this call as well.

So with that, Jonathan, you can take the first question.

Question-and-Answer Session

Operator

Certainly. And our first question comes from the line of Jeremy Benatar from Raymond James.

Jeremy Benatar - Raymond James & Associates, Inc.

Yes. Just quick housekeeping question. I think last quarter you guys guided to cash taxes between $25 million and $29 million for the year. Any change in that?

Andrew H. Del Matto - Chief Financial Officer

No change there, $25 million to $29 million.

Jeremy Benatar - Raymond James & Associates, Inc.

Got it. Okay. That's it from me. Thanks, guys.

Operator

Thank you. Our next question comes from the line of Gregg Moskowitz from Cowen and Company. Your question, please.

Gregg Moskowitz - Cowen & Co. LLC

Okay. Thanks very much. Hi, guys. So, with the Q1 out of the way, are there any potential transition issues that you would say are associated or could be associated with the unified global sales model that we should be aware of or is this pretty much in the rearview mirror as far as you're concerned?

Andrew H. Del Matto - Chief Financial Officer

Well, we called it out, as still the changes have been made. Somebody asked if we had some new people still to come in, we're always going to have some new people come in and not all, so maybe a few places to fill, if you will, but the structures are in place, the alignment is there. Gregg, I think the big caution is that there is some remapping that occurred in the rearview mirror. But when you transition, there is always six months to nine months of sell cycle, maybe even longer than nine months in some cases that we need to be cautious about and we reflect that in our guidance.

Gregg Moskowitz - Cowen & Co. LLC

Exactly, perfect. And Ken, last quarter, I think you said that there were some larger enterprises that were taking a little longer to make decisions. Has that dynamic continued or has that changed one way or another?

Ken Xie - Founder, Chairman of the Board and Chief Executive Officer

Not particularly.

Michelle Spolver - VP-Corporate Communications & Investor Relations

Remember our commentary last time. I think what we're talking about is that because security was becoming more strategic and they're more levels involved, I think as people were talking about emergency spending and that it's shortening the deal cycle or the deal time, you're talking about that, in some cases it might elongate it because it's gone up to sort of a board level for approval and its customers are taking more of a strategic look to security. So I think that if I remember correctly, I think that's the context of the statement last quarter. And I will think that we need a change.

Gregg Moskowitz - Cowen & Co. LLC

Okay. Great. And just a couple of other quick ones. We've heard that you may be looking to make some changes to your website potentially. Can you speak to that and just kind of what you're aiming for there?

Michelle Spolver - VP-Corporate Communications & Investor Relations

Wow!

Andrew H. Del Matto - Chief Financial Officer

A very good question. Absolutely the case. We did change the website and we launched the new – yeah, we are going to, sorry...

Michelle Spolver - VP-Corporate Communications & Investor Relations

Yeah, yeah.

Andrew H. Del Matto - Chief Financial Officer

...forthcoming and we've also updated our Partner Portal, which I believe is launched.

Michelle Spolver - VP-Corporate Communications & Investor Relations

Yeah. It's part of the awareness building and it's part of the plan in terms of increasing awareness and building awareness in addition to fresh content and a fresh-looking feel for the website. There is a lot that's enabled in the website to help drive demand, better web, better search engine optimization and things like that. So I think it's all designed to sort to help drive better demand for Fortinet.

Ken Xie - Founder, Chairman of the Board and Chief Executive Officer

It was more helping the lead gen and also more interactive and also target some – like customized for some of the reach in the customer, which they may have a different need. So, that's where we feel we'll be helping us out a lot.

Gregg Moskowitz - Cowen & Co. LLC

Okay. That's really helpful. And then I guess just lastly getting back to the CMO search, and I know you've classified your marketing team as being strong as it stands today, but what type of person are you looking for in terms of bringing in and I guess what will be a reasonable timeline in your view?

Andrew H. Del Matto - Chief Financial Officer

First of all, we're saying global marketing lead. We haven't really given it a title, Gregg, but global marketing lead and the timeframe, it's hard to predict. I mean it usually takes anywhere between four months to seven months to recruit someone. We're going to be very careful and cautious about who we recruit. Ideally it's someone with certainly knowledge of the street base. We want someone who can help enable our partners and drive better market awareness and help build that go-to-market machine that would really help us drive the growth. Somebody with experience doing that and a proven track record of doing that is type of person we're looking for.

Ken Xie - Founder, Chairman of the Board and Chief Executive Officer

Also need to be like line up working together with sales better because that's where the sales and marketing really need to be closely working together to helping grow the company.

Gregg Moskowitz - Cowen & Co. LLC

Okay. Terrific. Thanks very much, guys.

Operator

Thank you. Our next question comes from the line of Saket Kalia from Barclays Capital. Your question, please.

Saket Kalia - Barclays Capital, Inc.

Hey, guys. Thanks again for taking my follow-ups here. First, maybe a dumb question, but can you dig just one level deeper on how a customer would use Security Fabric? Is this a separately billable product, and realizing it may be early, but any idea how might be priced whether it's a perpetual license or subscription, any color just on how it's used on pricing?

Andrew H. Del Matto - Chief Financial Officer

Well, it's all of the above. There is not a single product. The Fabric, it really ties together everything from the expanding – think of the expanding attack surface basically where you now have IoT, cloud, more apps, more use of data. And so you could sell – it's just the breadth of the portfolio you're looking to sell at the end of the day from a WiFi product into the FortiGate class, into controllers and it could be virtual or physical at the end of the day and we sell the subscriptions as well.

We also think it's something that will be interesting to our partners because of the broader concept, thought leadership to sell to the customers, and we're calling it – it's an open architecture, so the more people – technology partners that we bring to the table also helps the partners sell more product as well. So that's a good way to think about it. So it's really more products and that's what we're really trying to do. In some cases, that could be up-sell, cross-sell. In some cases, it could be a new customer who was just – hopefully a larger PO coming in the door – larger initial PO with more products on it.

Ken Xie - Founder, Chairman of the Board and Chief Executive Officer

Yeah. It's more tied to helping customer, most enterprise customer to ease and also help them manage this better because otherwise there is too many different solutions from different vendors. And also, you talk about pricing is the area we may keeping improving like have some we call the enterprise-level pricing model compared to an individual product pricing model which we are kind of need keeping improving in that angle also. So that's basically is really helping the enterprise customer to easy management, easy pricing and a more secure solution, put all things (07:58) working together.

Saket Kalia - Barclays Capital, Inc.

Okay. Got it. And as my follow-up, Drew, you talked about in the Q&A session from last call, the different subscription bundles, right, whether it's UTM or enterprise, and again, realizing it's early on the enterprise bundle, but are you seeing any change in attach rates, maybe just in sort of early days, for high-end appliances and maybe opting for the enterprise bundle versus UTM?

Ken Xie - Founder, Chairman of the Board and Chief Executive Officer

The enterprise bundle just started like early this year. It's still relatively early. And also, the enterprise bundle need to depend on the new FortiOS 5.4, which also just released this year, and so still early to say what the attach rates yet.

Andrew H. Del Matto - Chief Financial Officer

Again, I would characterize it as both an initiative – as Ken said, I think the FortiOS 5.4 release is helpful, and then obviously just an opportunity for us going forward.

Saket Kalia - Barclays Capital, Inc.

Got it. Very helpful. Thanks, guys.

Operator

Thank you. Our next question comes from the line of Walter Pritchard from Citi. Your question, please.

Walter H. Pritchard - Citigroup Global Markets, Inc. (Broker)

Hi. Thanks. I'm wondering, Drew, if you could just help us through the specifics on – you said that the way you are accounting for the price increase on renewals impacted the split between long-term and short-term defers. I guess I didn't totally understand that. It would seem like – what would be deferred, whether it's recognized in one year or beyond a year, would both be impacted by the price increase and you wouldn't necessarily see some sort of allocation shift. And it does look like whether you look at it quarter-to-quarter or year-over-year, your long-term did grow quite significantly more than your short-term deferred. So that's the context of the question.

Andrew H. Del Matto - Chief Financial Officer

Well, it's been growing about a point a quarter is really the concept. And my issue was, if you amortize something at a lower cost and it comes off a lower cost transaction (09:53) renews at a higher cost, then you would have more long-term deferred.

Walter H. Pritchard - Citigroup Global Markets, Inc. (Broker)

Okay. All right. Maybe we'll (10:04) try to follow up on that one. And then just on the segments, I know you're not breaking out Meru, but can you tell us, are you putting Meru into the low end, the mid range or the high end in terms of product segmentation or is that excluded from the product segmentation?

Michelle Spolver - VP-Corporate Communications & Investor Relations

It's excluded from the product segmentation because the product breakouts that we give now is FortiGate billing.

Walter H. Pritchard - Citigroup Global Markets, Inc. (Broker)

Yeah, okay, got it. And then lastly, just on margins, you talked about 20% margin, I think, a number of calls ago as a kind of medium term goal. I assume there is no change in that, but we haven't heard – we didn't hear you talk much about that on the call. Where are you still on that medium term goal and any final (10:47) timeframe around it?

Ken Xie - Founder, Chairman of the Board and Chief Executive Officer

Yeah, that's the one we talk about. By 2020, we try to reach 20% operating margin, so we intend to be moving 1% per year going forward. We still have that target.

Walter H. Pritchard - Citigroup Global Markets, Inc. (Broker)

Okay, great. Thank you very much.

Ken Xie - Founder, Chairman of the Board and Chief Executive Officer

Thank you.

Operator

Thank you. Our next question comes from the line of Gabriela Borges from Goldman Sachs. Your question, please.

Gabriela Borges - Goldman Sachs & Co.

Great. Thanks for taking the follow-up. Just a quick one on FX at some of your international customers. I know you price in U.S. dollars, but have you seen any impact from purchasing power at some of your customers overseas and whether that's last year or maybe into this and maybe stabilizing a little bit?

Andrew H. Del Matto - Chief Financial Officer

We haven't seen anything. We haven't seen an impact. Again we had, I think, very nice margin on the product revenue side in the quarter, which we didn't feel like we saw a lot of pricing pressure quite frankly.

Ken Xie - Founder, Chairman of the Board and Chief Executive Officer

Also, we tend to be competitive both on the function, pricing and performance, so we don't see any pressure.

Gabriela Borges - Goldman Sachs & Co.

That's helpful. And then just on the marketing investment, curious, as we think about the run rate of investments through the year – when you get a (12:06) I imagine that will be a little bit of a step-up on the margin, but aside from that, is there anything big in terms of step-ups in marketing that we should expect today?

Andrew H. Del Matto - Chief Financial Officer

There's nothing we should call out specifically. We've guided for the year, it's all within that envelope.

Gabriela Borges - Goldman Sachs & Co.

Okay. Thank you.

Ken Xie - Founder, Chairman of the Board and Chief Executive Officer

Thank you.

Operator

Thank you. Our next question comes from the line of Brent Thill from UBS. Your question, please.

Fatima Aslam Boolani - UBS Securities LLC

Good afternoon. And thank you for taking the question. This is Fatima on for Brent. I just wanted to dig into the traction you're seeing in APAC. This business, according to my numbers, has now accelerated its growth from a revenue perspective for four consecutive quarters. So, any help you can give me around sort of what the market dynamics there are. I mean are they just behind from a refresh perspective, are you pricing in JPY there, was there some sort of an FX tailwind, just kind of given what the yen's done? So any sort of color there to kind of highlight?

Andrew H. Del Matto - Chief Financial Officer

Fatima, hi. It's Drew. We bill in dollars. We believe it's just that we had not invested as dramatically there as we had elsewhere, and we're pushing the teams to do that and the investments paid off quite frankly. And so, that's an area we continue to look to invest more quite frankly.

Ken Xie - Founder, Chairman of the Board and Chief Executive Officer

We have tended to be a large strong product. We have very healthy and broad good partnership now over there. And just we under-invest in the sales capacities and marketing there. So once we add some investment there, we can see the growth starting to accelerate.

Fatima Aslam Boolani - UBS Securities LLC

Fair enough. And then just shifting gears from the market perspective, you've seen a tremendous amount of success kind of in the enterprise and kind of the sales of the Fortune 1000 not certainly a billing business, but you also have sort of a stranglehold in the low end of the market. I am wondering if there is more rooms for share gains kind of at the lower end where you had played more meaningfully historically and to what extent is your managed security services business with service providers cannibalistic to the very, very low end of the market?

Ken Xie - Founder, Chairman of the Board and Chief Executive Officer

Yeah. The low end we're still keeping growing nicely and independent (14:20) we are the number one, the number of units shipped or deployed globally, more than any other vendor. And the low end, from some research, we estimate we have probably like a 27% of market share, and with the technology we have, System-on-Chip, we have a huge advantage compared to another competitor. They have to load a server into a smaller PCo server to compete. We can put everything into a single chip. So that's where we feel we're keeping gaining share with the about same the rate we grow overall.

And we also have the high end of care and service provider and also the Fortune 100 company. The area we kind of under-invest is really the mid market – mid enterprise market side. That's where we're starting cover the sales capacities and marketing coverage that in – you mentioned that area and especially U.S. and that's also the global sales structure. The additional marketing investment will also help you drive the mid enterprise growth. That's where we have a pretty low percentage compared to the low end and high end. We've fueled the investment where we're helping grow in the mid market.

Fatima Aslam Boolani - UBS Securities LLC

That's very helpful. And last one from me, if I could sneak one in. You talked about the momentum you are seeing with the FortiSandbox, it tripled two quarters ago, then it quadrupled and it grew almost 300% year-on-year from a billings perspective this quarter. Can you help us frame what type of penetration you're seeing with respect to your 270,000 customers and what's the predominant method of adoption? Is it more kind of the bundled service or is it the appliance, any color on those would be really helpful? And that's it from me, thank you.

Ken Xie - Founder, Chairman of the Board and Chief Executive Officer

It's more like we call the Fabric that could sell in together and that's where we're working with the FortiGate, FortiMail, FortiWeb together with FortiSandbox is the solution. That's where it's still relatively small customer base because most the Sandbox buy usually towards the big enterprise, the more high end side of a customer, but we also starting offer the ATP into the FortiGate, a new 5.4 FortiOS and also enterprise bundle. That also eventually was helping drive the ATP solution to the more broad market. And same kind of new – the new FortiGate, we announced the FortiGate-6000, FortiGate-2000, I think will also helping buyer (17:03) basically.

Sandbox is one example of Security Fabric and working together, thus drive the up-sell, cross-sell. So, that's where we see not only the Sandbox, but some other solution like e-mail, FortiMail, FortiWeb. Some other also starting to ramp up quicker than the overall company growth, so that's what's helping drive the up-sell, cross-sell.

Operator

Thank you. Our next question comes from the line of Melissa Gorham from Morgan Stanley. Your question, please.

Melissa A. Gorham - Morgan Stanley & Co. LLC

Great. Thanks for taking my question. Drew, I just wanted to ask you about use of cash, and apologies if this has been asked, because I was hopping back and forth, but – so you bought back some shares this quarter. You've been somewhat acquisitive, but not hugely acquisitive in the past, so I am just wondering how you think about the opportunity of continued share buybacks versus consolidating further security functionality through acquisitions?

Andrew H. Del Matto - Chief Financial Officer

Melissa, we haven't been asked that question today, which is unusual at this point.

Melissa A. Gorham - Morgan Stanley & Co. LLC

Okay.

Andrew H. Del Matto - Chief Financial Officer

The strategy remains the same. We continue to invest for growth, primarily organic. We're very good at driving organic growth as reflected in our Security Fabric that we announced. You're right, we've done really what have been, I would say, tuck-in acquisitions, and I would even characterize Meru in some ways more of (18:33) in terms of getting a pretty big R&D team with WiFi experience, with wireless experience and the idea there to inject security. But clearly, we're looking at opportunities that make sense.

If you think about the Fabric, consolidation makes a lot of sense in customers who are looking to consolidate. We've heard customers basically complain about. There are just too many security vendors in their environment. They're really looking to consolidate. We hope to do that with the Security Fabric, make that an open architecture as well, and provide our ability to have a common operating system across all the way from WiFi into the data center and doing it in a very high level of performance and security. So, clearly we're looking at opportunities there.

And then from a buyback perspective, I think you can look at our history of where we're buying back. We talk about those. I think there is $150 million remaining of the $200 million, but we will stick to the guidance on that. We tend to be very opportunistic, and when we buy back, we try to buy back more in the price ranges we brought back historically.

Melissa A. Gorham - Morgan Stanley & Co. LLC

Okay. That's helpful. That's it for me. Thank you.

Operator

Thank you. Our next question comes from the line of Sterling Auty from JPMorgan. Your question, please.

Sterling Auty - JPMorgan Securities LLC

Yeah, thanks. Hi, guys. I've been hopping around as well. I had two technology questions that hopefully haven't been beat on. But when you look at both the ninth-generation chip that you have introduced, and especially in the Fortinet 6000 series. I think one of the speed differentials you've had has been kind of like the 48-gigabit backplane ability to do it without core aggregation, et cetera. What have you done in the new generation of appliances especially in the 6000 to take that maybe to a new level, are you still at the same kind of performance level on the backplane as the previous generation?

Ken Xie - Founder, Chairman of the Board and Chief Executive Officer

The backplane definitely a few times faster, but most important really we want to drive the computing power for the next-gen firewall function, which involve in the like intrusion prevention, the malware, antivirus and that other like SSL level encryption. So, that's the big need and change because the traditional firewall function, we take that on the network process level, that's where the traditional firewall, VPN. We don't have a huge performance advantage, but when go to the content side and that's where the intrusion, the malware, virus and the like web content, that's where the CP9 content processor and also the new 6000 architecture may double, triple than the previous like whether the 3000, 5000 platform on the single blade side. That eventually will have also – the backplane speed also help a lot.

So, that's where the advantage we'll have both leverage the system level architecture, which has a much better improvement in the past (21:50) in the other side and also the computing powers and also the CP9. This will be – eventually will help in move the security from the current firewall, VPN, traditional connection level security to the content application level, which the content processor, the 6000 will really lead in the space.

Sterling Auty - JPMorgan Securities LLC

And then separately, when you look at the Security Fabric, is that something that when you're tying all the things together, as you showed on your slide, is this an indication of other areas that you plan on expanding into with your own Fortinet solution, whether I think about endpoint or other, or how much are you going to rely on the partnerships and kind of the ecosystems to provide that high-end functionality in some of those spaces?

Ken Xie - Founder, Chairman of the Board and Chief Executive Officer

We're keeping both – we are keeping develop internally. We have pretty strong engineering team here, but also we're keeping – we're open for the third-party partner including both from the endpoint, even some solution we have, we also want to open for the partner. And because the management cost is very big, it's huge than the product cost in most enterprise environment. That's we're making all these different solution working together. I think we try to leverage. We're already the number one of the most deployed network security solution there and also adding the WiFi and some endpoint and also some application like email, web (23:20) and the DDoS and the ADC will also help into – get all this together. And that's where the Fabric is really open for both internal and also for the partner to helping manage and merging together reduce the management cost.

Sterling Auty - JPMorgan Securities LLC

Got it. Thank you.

Ken Xie - Founder, Chairman of the Board and Chief Executive Officer

Thank you.

Operator

Thank you. Our next question comes from the line of Catharine Trebnick from Dougherty. Your question, please.

Catharine A. Trebnick - Dougherty & Co. LLC

Yeah, thank you for taking my question. I have one on your geographic reach. Is there any way – you just talked in the last call that in the United States 65% roughly or 65% of the service MSSP is related to the service provider business. I am trying to get a handle geographically, like in your EMEA or Asia-Pac, how much of that revenue is service provider related, and then how much of that might be related to the MSSP business.

Ken Xie - Founder, Chairman of the Board and Chief Executive Officer

Yeah. I don't have maybe quite some better (24:29) numbers. My gut feeling is really, in U.S., we're a little bit more towards the MSP and compared to some international because the U.S. is – like we said in earning (24:46), we have pretty much all the major carrier service provider as our customer, but in U.S. is really the MSP also helping drive a lot of enterprise and other service for us. International, some of the service provider not as large or global as some of the big U.S. one and thus they may be a little bit towards the – not quite as (25:13).

Michelle Spolver - VP-Corporate Communications & Investor Relations

Catharine, let me just actually make sure that the question – that what I said was sort of thought on correctly is that basically what I said was roughly within our global service provider business, roughly 65% to 70% of that was for MSSP deployment. So I wasn't saying that it was 65% of U.S. business or Americas business, it's of our global service provider business.

Catharine A. Trebnick - Dougherty & Co. LLC

Okay. Thanks for the clarification.

Michelle Spolver - VP-Corporate Communications & Investor Relations

Yeah, fine.

Catharine A. Trebnick - Dougherty & Co. LLC

So then another question is like if I take EMEA then, how much of the European business would be related to the service provider versus enterprise?

Michelle Spolver - VP-Corporate Communications & Investor Relations

Yeah. And see, we don't break up the verticals by region. It's...

Catharine A. Trebnick - Dougherty & Co. LLC

I know. I was just trying to...

Michelle Spolver - VP-Corporate Communications & Investor Relations

I guess we don't have the answer and we don't break it out anyway, but I mean service provider is 22% of our global billings, and then we don't break it out of how much it is per region (26:07).

Catharine A. Trebnick - Dougherty & Co. LLC

All right. At least I thought I would try. Thank you.

Michelle Spolver - VP-Corporate Communications & Investor Relations

Okay.

Operator

Thank you. Our next question comes from the line of Ken Talanian from Evercore ISI. Your question, please.

Ken Talanian - Evercore ISI

Hi, guys. Thanks for taking my question. First one, do you have the deferred breakdown between product and services for this quarter and last quarter?

Andrew H. Del Matto - Chief Financial Officer

Well, there is not much – we don't break it out, Ken. But there is not much product.

Ken Talanian - Evercore ISI

Okay.

Andrew H. Del Matto - Chief Financial Officer

Very small.

Ken Talanian - Evercore ISI

Okay. Very small amount of product.

Andrew H. Del Matto - Chief Financial Officer

(26:38)

Ken Talanian - Evercore ISI

Okay. And then my second question. Just thinking broadly about the competitive environment, you're seeing increased spending from Check Point in sales and marketing. Palo Alto continues to be strong. As I listen to some of your commentary around your own sales and marketing investments, it sounds like you're largely there, there are a couple of people you need to add in, you need a global marketing leader. And then at the same time as you look forward, you remain somewhat cautious on the environment. Is part of that the competitive environment? I mean, do you expect that you'll either have to add more product to win a comparative deal, you'll expect to do more discounting? Is there any of that factored into your expectations?

Andrew H. Del Matto - Chief Financial Officer

I'm not sure I understand the question, Ken.

Ken Xie - Founder, Chairman of the Board and Chief Executive Officer

Yeah, (27:33) I can answer. You can look under (27:37) report. We also showed in the ISC Show (27:43). We're much better both on the security function and also the price performance compared with other competitors. And also we are very unique; we develop our own ASIC chip and also heavily invest in the systems side, that's the new product we're keeping driving, leading the space and like internal segmentation, we don't see any other competitor come close to what we have. We're keeping the pace and keeping innovating leading, but we don't see price pressure from our competitor, because we are leading in that area and with the performance, the function we have.

Drew, do you want to...

Andrew H. Del Matto - Chief Financial Officer

Yeah. I mean, we absolutely don't look forward to just getting (28:29) prices. That's not something we would certainly plan for. It's not part of our strategy. I mean, if think about it simplistically, it's great volume, right? You want to acquire customers which is the volume and then do it at a higher rate which is price. And the more we can add to the bundle and charge more, the more we up-sell, cross-sell really helps those economics and again we've been investing and very successful at acquiring new customers, and so that's really how we think about the model.

Ken Xie - Founder, Chairman of the Board and Chief Executive Officer

Yeah. We kind of go the other way. You can see one year ago we reached the bundle price and now we're starting to offer the enterprise bundle which have two additional new (29:06) service, the ATP module (29:08) and cloud security, so that also will help in making the per box total solution go to this higher price (29:16).

Ken Talanian - Evercore ISI

And I appreciate that. I guess part of the question was also, it's obviously to your advantage to add more richly-configured subscriptions to deal, but do you feel that that's a necessity at this point?

Andrew H. Del Matto - Chief Financial Officer

A necessity, I think it's a strategy.

Ken Talanian - Evercore ISI

Okay.

Ken Xie - Founder, Chairman of the Board and Chief Executive Officer

Yeah. Also we have the technology the product can do that and because that's where the new content processor, the new (29:53) architecture add a lot of computing power and a lot of function in that hardware which will help in drive the multi-function, integrate consolidated function there, at which the other competitor if they don't have the CPU, which will be more and more difficult to consolidate more function into the CPU, which we have the ASIC offload (30:18) both on the content processor side, on the network processor side.

Andrew H. Del Matto - Chief Financial Officer

And then Ken, just a close off on the strategy part about it. Customers want to consolidate vendors. They're looking to make it simpler to run the business journey. The more that we can add, we're generating – we're providing more value to the customer. It also makes for ease of deployment, ease of management, and so when we look at the overall bundle and the opportunity to enrich the platform, whether we added to the bundle or elsewhere, you may add it on top of it and price it separately, that's really the strategy.

But again go back to rate and volume, yeah, we're absolutely looking for ways to increase the ASP on the bundles, if that make sense. If not, we may just look at doing it separately. But again those vectors are there. Consolidation, clearly that's out there. People are looking for platforms, Security Fabric addresses that. The more we can do to make it easier for them along deployment or management, then the more value we're providing and the more we're inside of the charge.

Ken Xie - Founder, Chairman of the Board and Chief Executive Officer

Yeah, you can see it's been in the SMB space, right, so we've become a number one three years ago, but with leading technology, now we're probably more than doubled the number two now, and that's where the advantage we have on the system platform, and the System-on-a-Chip Solution that will help in driving a lot of additional value compared to competitor, and also gaining share quickly, that's where we're hoping to expand into the mid-enterprise and also the service provider space.

Ken Talanian - Evercore ISI

Understood. Thank you very much.

Ken Xie - Founder, Chairman of the Board and Chief Executive Officer

Thank you.

Operator

Thank you. Our next question comes from the line of Taz Koujalgi from Deutsche Bank. Your question, please.

Imtiaz Koujalgi - Deutsche Bank Securities, Inc.

Hey, guys, thanks for taking my question. You mentioned in the last call that the contract duration had not changed quite a – I mean, a much from previous quarters. What was the duration in this quarter, and what's the typical rate been in the last couple of quarters?

Andrew H. Del Matto - Chief Financial Officer

It tends to range between 18 months and 22 months...

Michelle Spolver - VP-Corporate Communications & Investor Relations

It hasn't changed.

Andrew H. Del Matto - Chief Financial Officer

...within that range. Yeah.

Imtiaz Koujalgi - Deutsche Bank Securities, Inc.

Got it. And then you mentioned that the price increase was the main driver for the long-term deferred mix going up, so if I can understand, you've had a few price changes in the last few quarters, I think, I just want to walk through which of the price change you're referring to when you talk about the increase in deferred mix, because you had a change in your plans pricing, I think over the last year, which I'm assuming should not have a big impact on the deferred (33:01)...

Andrew H. Del Matto - Chief Financial Officer

It would be on subscription, the deferred piece, it's not product, it would be the subscription.

Imtiaz Koujalgi - Deutsche Bank Securities, Inc.

Right. So and then I think Ken said that the enterprise...

Andrew H. Del Matto - Chief Financial Officer

But that wouldn't be long-term. There wouldn't be any long-term product, right, you ship the product.

Imtiaz Koujalgi - Deutsche Bank Securities, Inc.

Right. Right. And then I think Ken mentioned that the enterprise bundle is still very early. So I'm assuming that didn't have much of an impact on the long-term deferred. So is it the UTM bundle price increase that you had last year, which impacted the long-term deferred mix?

Andrew H. Del Matto - Chief Financial Officer

Yeah. Look I mean, Taz, I think we'll follow-up on the math on this, but the theory is if you're rolling something off at one price, which is lower, and renewing it at a higher price again, you're building deferred over the last year at a higher – long-term deferred at a higher price.

Imtiaz Koujalgi - Deutsche Bank Securities, Inc.

Okay. A little follow-up, but I'm just confused why the mix would shift (33:42), because I thought this short-term and long-term...

Andrew H. Del Matto - Chief Financial Officer

Okay.

Imtiaz Koujalgi - Deutsche Bank Securities, Inc.

...deferred should both impact it equally...

Andrew H. Del Matto - Chief Financial Officer

It went up about a point.

Imtiaz Koujalgi - Deutsche Bank Securities, Inc.

Okay.

Andrew H. Del Matto - Chief Financial Officer

It's been trending up.

Imtiaz Koujalgi - Deutsche Bank Securities, Inc.

I'm sorry. Can you repeat that, please?

Andrew H. Del Matto - Chief Financial Officer

It has been trending up over the last year, and you're building, you're growing, and we'll follow-up.

Imtiaz Koujalgi - Deutsche Bank Securities, Inc.

Okay. No worries. And then on the product revenue side, you had a – your seasonality on overall revenue was fairly in line with your typical Q4 to Q1, but then on product revenues, it seemed a bit lower than what you could (34:16) for the Q1 sequential growth is, and I remember that you had a price increase in the appliances early last year. So why the lower seasonality from Q4 to Q1 on the product line this quarter?

Andrew H. Del Matto - Chief Financial Officer

Well, the product we're down – it's a little more than last year, it always drops from Q4 a little bit. Taz, I don't have a better explanation of that, again it could be a function of pricing or how they buy or what they're buying at that point in time. Again, we're more focused quite honestly, to be fair, again, we're more focused on driving the recurring revenue stream, again at the higher ASP. And so as you tilt towards that, that's going to influence the balance of that mix more towards services lines.

Imtiaz Koujalgi - Deutsche Bank Securities, Inc.

Yeah, the mix mostly went...

Ken Xie - Founder, Chairman of the Board and Chief Executive Officer

Most of the product price, I don't think it's been changed now. And we just had one product last year; we tried to line up – the 1500D, tried to line up the international price with U.S. price maybe better. I don't think we changed anything else, and also that's not by that (35:36) another increase. It's really just line up the global price maybe better.

Imtiaz Koujalgi - Deutsche Bank Securities, Inc.

So there's no change in product mix over last quarter or last year which drove the seasonality lower than the typical?

Andrew H. Del Matto - Chief Financial Officer

Taz, I think we're just more focused on driving recurring revenue streams, and you're seeing that manifest itself in the services line flowed up (36:01).

Imtiaz Koujalgi - Deutsche Bank Securities, Inc.

Yeah. That was a good uptick. But if I would follow-up on that service line picking up, is there a way to quantify the attach rates? I mean, your services line did go up quite a bit seasonally versus last year. Is there a way to quantify what the tax rate was typically, and then what the tax rate of the services was this quarter, which drove that services line higher?

Andrew H. Del Matto - Chief Financial Officer

Taz, we haven't been sharing attach rates.

Imtiaz Koujalgi - Deutsche Bank Securities, Inc.

But it was higher than previous quarters?

Ken Xie - Founder, Chairman of the Board and Chief Executive Officer

Yeah. We shared – right now, the renewal, we try to base on the product which is mid-70% (36:36), but if you consider the product yield is survive in the network environment for like four years, five years, so that's where translates to over 90% – high 90% of the customer retention rate there, because even same customer when they buy the new products, we don't consider as renew, we consider as a new. So that's where, because we have the channel models, sometime maybe difficult to track in customer directly. But that's where we do gave the customer retention rate is 70% in the product level. We believe the customer level probably over 90% or in the high 90%s.

Imtiaz Koujalgi - Deutsche Bank Securities, Inc.

Understood. I was referring to the attach rate on the subscription

to the appliances.

Michelle Spolver - VP-Corporate Communications & Investor Relations

Yeah, I mean, so Taz, sorry, I know we're spending a lot of time here, but it's an important question. So the attach rate, the reality is that from the beginning we had roughly 80% of our customers that were buying subscriptions and buying bundles since inception. So whereas other companies have introduced new subscriptions services along the way, we haven't done that with the exception of the enterprise bundle that was just sort of made available in Q4.

So outside of that, we've been enriching with features of existing bundles, but it's hard to talk about attach rate trend when from the very beginning the vast majority of our customers were buying the bundles. So I think that's the way I'd explain that.

Imtiaz Koujalgi - Deutsche Bank Securities, Inc.

That's helpful. The reason I was trying to build on that is because you had a price increase in the UTM bundle. So I was trying to get a sense of how much of the increased service revenue was coming from the – an increase in attach versus increase in the pricing that you had in the UTM bundle.

Andrew H. Del Matto - Chief Financial Officer

Got it.

Michelle Spolver - VP-Corporate Communications & Investor Relations

Right. No, I understand. It's almost all from the increase in pricing, just because, again, we're starting off a big base of customers, and the buying trend for Fortinet customers has always been to buy it with the – unless you're using it for a straight firewall,

the trend has always been to buy the subscription. So you're not going to see a trend line go up like you have with other companies – because they've introduced, they started with nothing and they're introducing subscriptions along the way. It's sort of the growth in services was almost all driven through the price increases.

Imtiaz Koujalgi - Deutsche Bank Securities, Inc.

Got it. That's very helpful. Thank you.

Michelle Spolver - VP-Corporate Communications & Investor Relations

Thanks.

Operator

Thank you. Our next question comes from the line of Erik Suppiger from JMP Securities. Your question, please.

Erik L. Suppiger - JMP Securities LLC

Yes. I just had a couple on the cash flows. It looks like you're going to be spending about $25 million more over the course of the year on CapEx. Can we assume that's a linear $8 million per quarter?

Andrew H. Del Matto - Chief Financial Officer

So we guided $55 million. Are you saying – I'm not sure what the $25 million is, but we guided $55 million.

Erik L. Suppiger - JMP Securities LLC

Well, you did $30 million in the quarter, so...

Andrew H. Del Matto - Chief Financial Officer

Yeah, for the rest of the year. I see what you're saying. Yeah, so $55 million. We don't really – it's hard to guide on that. I mean, it depends on the timing of a few things quite frankly. We're still buying some real estate deals and it's really kind of hard to predict the timing of those.

Erik L. Suppiger - JMP Securities LLC

Okay. Anything...

Andrew H. Del Matto - Chief Financial Officer

(39:40)

Erik L. Suppiger - JMP Securities LLC

Anything to think about from a seasonality in terms of your free cash flows for the June quarter or how we want to model that going forward for the next three quarters?

Andrew H. Del Matto - Chief Financial Officer

I don't have anything to add on that, Erik.

Erik L. Suppiger - JMP Securities LLC

Okay. Then lastly, deal size. You'd said the deal size for some of these internal segmenting opportunities, the firewall segmenting opportunities, is in the six-figure type range. Is that because this is still very early and maybe over the course of this year we can start seeing some seven-figure size deals in internal firewalling or is that not in the nature of that market opportunity?

Michelle Spolver - VP-Corporate Communications & Investor Relations

Sure, Erik. It depends on how big a customer's network is. So if you're talking, the largest – say a huge, huge investment bank, the largest networks in the world, they would probably do more segmentation, there's more areas to segment, they would use more firewalls. If you're talking to mid-size enterprise, the network isn't so broad that they would put that many in. So I don't that it's that the deal size will grow. It's not really an issue of that unless we – as we start getting massive, massive customers, which we already kind of are starting to do that. It could, but that's not really the way you'd look at it. I think you'd look at the growth coming from additional customers or expansion opportunities.

Erik L. Suppiger - JMP Securities LLC

In a given account, can you give us a sense with the opportunity for a traditional perimeter firewall buildout versus an internal segmenting, how you might look at that?

Michelle Spolver - VP-Corporate Communications & Investor Relations

Are you asking – I don't understand what you're asking. You're asking from a dollar perspective like what would a perimeter cost (41:22)?

Erik L. Suppiger - JMP Securities LLC

Yeah, what would be the – kind of what would be the proportion? Is the internal segmenting a quarter of the size of the perimeter deployment or how might we think about that?

Michelle Spolver - VP-Corporate Communications & Investor Relations

Again, it depends on the customer. So a large investment bank would probably be different than a mid-size company. I mean, if you want, I can do a follow-up call with you. I mean, maybe what I can do is dig out – and I don't have it in front of me, but give you a real world example of a deal, because we have talked about expansion deals, one that started as an internal firewall and expanded – it was actually more – expanded more to a traditional perimeter or a core firewall. So I could probably give that to you. I just don't have that at my fingertips right now.

But again, it all solely depends on the type of customer. If you're going to – if you have a very expansive, huge network that you're going to do a lot of segmentation, you'd need a lot of internal firewall. If it's a mid-size company that you want to protect your finance server and your R&D server, you need two. So, just so you understand, there is a large enterprise, traditional enterprise, mid-size enterprise and they're all going to be different.

Ken Xie - Founder, Chairman of the Board and Chief Executive Officer

Yeah. If you see some early research based on the switch market, which is about $40 billion, $50 billion, some portion of that, like there are some studies see what are the mPOS (42:35) does have some segmentation, whether it will go to the internal segmentation firewall. But the internal segmentation firewall offer much more than the switch level, whether the VPN or some other. They also cover the intrusion prevention, the content and the applications, so there is a much richer function, higher level screening compared to the switch can do.

And that's where – there's some research says it's a few billion dollar, will drive like a 6% to 8% additional growth. But it's still early stage. I'd say it sometime depend on the vertical. Like to mention sometime the finance service industry, the healthcare industry, and some other big enterprises may like a – more like an early adopter of the internal segmentation. Because the switch just connect everything to everything (43:32) is not quite a secure working for all these vertical space. But it's a – they see the huge value, but on the other side, on the per gig throughput, the network securities feel like almost 100 times more expensive than a switch.

So that's where it's difficult to use in a switch market or justify it because network security need will have a much higher huge computing power processors theme (44:02) throughput of traffic compared to the switch. And so that's we're still in an early stage, but we see it's a huge opportunity.

Erik L. Suppiger - JMP Securities LLC

Very good. Thank you.

Ken Xie - Founder, Chairman of the Board and Chief Executive Officer

Thank you.

Operator

Thank you. Our next question comes from the line Rohit Chopra from Buckingham Research. Your question, please.

Rohit Chopra - The Buckingham Research Group, Inc.

Yeah. Couple of questions. Ken, I just want to come back to that last question, are you saying that the internal segmentation firewall is or can replace traditional switching, it's just expensive now, but as the price comes down, you could actually see yourselves taking share in the traditional switching market?.

Ken Xie - Founder, Chairman of the Board and Chief Executive Officer

I'd say it's deployed and where the switch deployed and also together with the switch, because it's different than the traditional deployment, which only deploy on the (44:55) where a company connects with Internet, because it deploy internally, which are part of replacing some of the switch.

But switch is still much lower cost, more popular compared to the internal segmentation. They have the same deploy mode, the function of the switch, but additional security function which the switch networking gear cannot cover. But on the pricing side is that, per gig or per 10-gigs feel like almost 100 times more expensive than the switch.

Rohit Chopra - The Buckingham Research Group, Inc.

Yeah. Okay. All right. And then, just correct me if I am wrong, segmentation isn't necessarily new, it's just that the functionality is different than older segmentation as we know, it's like port-based or whatever people are doing before, it wasn't very flexible. And now on an application basis, it's much easier and what you're really trying to do is segmentation is trying to minimize the – like any issues that could happen, if there were some kind of threat, is that a good way of thinking?

Ken Xie - Founder, Chairman of the Board and Chief Executive Officer

Yeah, it's a little bit different than the traditional MPR (46:05) segmentation, which they separate as a different group cannot connect or be pinned (46:13) together. It's really they keep the connection, but control the higher layer intrusion, more virus content, which the switch cannot see, cannot distinguish, that's where the internal security segmentation really keeping the switch level connection there and the same time screen the content, the malware intrusion.

Rohit Chopra - The Buckingham Research Group, Inc.

Okay. All right. And my last question was just one HP. I think there was an announcement with HP back in, I'm going to say March. Any progress there with HP and any integration? I think there was some integration activities going on.

Ken Xie - Founder, Chairman of the Board and Chief Executive Officer

We do partner with quite a lot of companies, including HP, both on the network side on the access, and even in the endpoint side, that's where the Security Fabric, I think the Security Fabric will be helping accelerate partnership including the partnership with HP.

Rohit Chopra - The Buckingham Research Group, Inc.

HP, okay. That's helpful. Thank you. Thanks. I appreciate it.

Operator

Thank you. Our next question comes from the line of Hendi Susanto from Gabelli. Your question, please.

Hendi Susanto - Gabelli & Company

Hi, again Ken and Drew. Ken, you sound excited about security application for IoT, some may argue that IoT is still in the early stage. In your view, which IoT application will be the early adopters of your Fortinet security solution, and how should we expect the trajectory of the IoT security opportunity?

Ken Xie - Founder, Chairman of the Board and Chief Executive Officer

I think IoT will be the trend in the next five years to 10 years, I know it's still relatively early including like a connected car, connecting appliance, all those things. But we do see the security need, and also we develop the technology like from a chip level to the cloud software and service provider infrastructure level, we're addressing that.

There are also some research come from some other research firm saying (48:10) the segmentation for the IoT will be the way for a solution which we agree, but also IoT has – basically the IoT security is a little bit different than a traditional user human level Internet security. That's where we want to like invest early and also make sure we can have a best solution once the market ramp up.

Hendi Susanto - Gabelli & Company

So is it fair to say that it's not the 2016 or 2017 opportunity in terms of its size?

Andrew H. Del Matto - Chief Financial Officer

Well, look, I think Hendi, that the point here is that look vision matters, right, to customers who are thinking about the future, there is some IoT out there, I think the large, the ubiquity of it probably is few years out to be frank, but customers addressing architectures today need to consider it. And so, one, it helps you give something good, talk about, you probably don't get near-term deals specifically from that, but you are selling an architecture longer term that this is a piece of it, and then customers know that that's something you can help them be ready for over the longer term.

Ken Xie - Founder, Chairman of the Board and Chief Executive Officer

Yeah, we are already like investing this year ahead of competitor like to build security into the chip indoor (49:27) which can be in the (49:28) there, and also like a ruggedized solution for the outdoor for some other, and also the WiFi access point. So that's a lot of what relate to the IoT, we feel it's also the future for IoT, but we do want to keep in the investment, we see that's a huge opportunity, we want to do like some investment and capture the huge opportunity going forward.

Hendi Susanto - Gabelli & Company

That's helpful. Thank you.

Ken Xie - Founder, Chairman of the Board and Chief Executive Officer

Thank you.

Operator

Thank you, and this does conclude the question-and-answer session of today's program. I'd like to hand the program back to Michelle Spolver for any further remarks.

Michelle Spolver - VP-Corporate Communications & Investor Relations

Thanks, Jonathan. I just would say thank you again everybody for joining the call and asking some really good questions. I know we owe you some follow-up information, I'll get that to you, and then feel free to reach out to me, if you have further questions. Thanks a lot.

Operator

Thank you, ladies and gentlemen for your participation in today's conference. This does conclude the program. You may now disconnect. Good day.

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