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Fortinet Inc. (NASDAQ:FTNT)

Q1 2012 Earnings Call

April 24, 2012 04:30 pm ET

Executives

Ken Goldman - CFO

Ken Xie - Founder, President and CEO

Analysts

Michael Turitz - Raymond James

Keith Weiss - Morgan Stanley

Rich Sherlund - Nomura

Sterling Auty - JPMorgan

Walter Pritchard - Citi

Erik Suppiger - JMP Securities

Brent Thill - UBS

Robert Breza - RBC Capital Markets

Jonathan Ho - William Blair

Aaron Schwartz - Jefferies

Scott Zeller - Needham & Company

Jayson Noland - Robert Baird

Phil Rueppel - Wells Fargo Securities

Brian Freed - Wunderlich Securities

Operator

Good day, ladies and gentlemen and thank you for standing by and welcome to the Fortinet Q1 2012 earnings announcement conference call. (Operator Instructions) As a reminder, today's conference may be recorded.

And now I will turn the floor over to Ken Goldman. Sir, the floors is yours.

Ken Goldman

Great, thank you and good afternoon for all of you joining us for this conference call to discuss Fortinet’s financial and operating results for the first quarter of 2012. Joining me today are Ken Xie, Founder, President, and CEO; and Michelle Spolver, Vice President of Corporate Communications.

In terms of structure of the call, I will begin with a review of our operating results before I turn the call over to Ken to provide additional perspective of the performance of our business. I will then conclude with some thoughts on our outlook for the second quarter and full-year 2012 before we open up for the questions.

As a reminder today, again we are holding two calls. Following this call, we will hold a second conference call to provide an opportunity for financial analysts and investors to ask more detailed financial questions. Second call will begin at 03:30 PM Pacific Time and will also be webcast from our Investor Relations website and is accessible as detailed in the earnings release.

Let me also start with this disclaimer and Safe Harbor statement. Please note some of the comments we make today are forward-looking statements, including those regarding our financial guidance for the second quarter of fiscal 2012, ability to execute on our 2011 momentum, market opportunities and our pipeline; expectations regarding product sales, deferred revenue balance, renewals, service revenues, product revenues and ratable on other revenue; impact of investments on our sales and R&D; expectations regarding inventory levels and our hiring trends; and expectations around our competitive position, benefit from market trends, market share and market share gains in general by geography, macro-economic environment and demand for security solutions.

These forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those projected in the forward-looking statements. Please refer to our SEC filings, in particular, risk factors described in our Forms 10-K and 10-Q for more information on these risks and uncertainties and you know the limitations that apply to our forward-looking statements. Copies can be obtained from the SEC or by visiting the Investor Relations section of our website.

All forward-looking statements reflect our opinions only as of the date of this presentation. And we undertake no obligations and specifically disclaim any obligation to update forward-looking statements.

Also please note that we will be discussing certain non-GAAP financial measures on this call. Our GAAP results and GAAP to non-GAAP reconciliations can be found in our earnings press release and on slides 14, 15 in the presentation that accompanies today’s prepared remarks. Please refer to investor.fortinet.com for important information including our earnings press release issued a few minutes ago and slides that accompany today’s prepared remarks. A replay of this call will also be available on our website.

So with that let me now talk to the Q1 results. We are pleased to report that Fortinet exhibited strong performance to start the year having again met or exceeded our expectations regarding all of our key metrics including billings, revenue, profitability and free cash flow. Our performance was driven by healthy business environment and continued demand for our core network security parts across all major geographies, the early acceptance of some of our recently launched products and by leveraging investments we have made in our sales and marketing teams.

Fortinet continues to increase market share by offering parts with speed to keep up with the real-world traffic, that powered (inaudible) complex IT infrastructures and the high performance that our customers demand. In addition to rolling out new mid-range and high-end products we demonstrated through third-party tests that our FortiGate-5140B is the world's fastest firewall.

Furthermore our new line of DDoS appliances which we announced this morning broaden our solutions portfolio and provide us with additional functionalities we can offer to our customers. As you will see from my numbers billings grew fast, the reported revenues in 1Q which is a good leading indicator of future business. Additionally product revenue grew faster year-to-year in total revenues thus indicating strength of product sales to new and existing customers.

One thing to note is 1Q12 revenues is under (inaudible) revenue recognition rules as we had in 1Q of last year. As you'll recall 2011 we got a bump in product revenue as a result of adopting new revenue recognition rules as that revenue also flat and the seasonality impact or effect we encountered in Q1 '11 compared to Q4 '10. In 2012 we actually encountered negative effect and in that we will see a decline in ratable revenue contributions.

Still okay. Before diving into financials of the first quarter I would like to highlight the performance of some of our regions and the business drivers that helped us succeed our goals this quarter. First our strong performance in North America was led by sales enterprise customers in the US along with continued strength in Latin America. We continue to win large core enterprise firewall deals with enterprises, PCI regulation compliance continue to drive business in retail and vertical and we benefited from contributions from both new and existing customers during the first quarter.

Second the (inaudible) has continued to show increasing strength and experienced the strongest growth in Q4 2010 despite the challenges in local economies. Billings of region accelerated nicely. We have a strong team in place and continue to grow and take market share there. In particular we saw a very strong performance in the UK and France, business drivers during the quarter were the continued driver of Fortinet's high performance firewall in UTM solutions especially among large enterprises and carriers.

Additionally we had strong runrate business and service contract renewals from existing customers. Third, we also did well in Asia Pac and saw a very strong growth in Japan as well as Korea. Across Asia-Pacific we have started to win more business with large enterprise accounts who were selecting our consolidated and security solutions and high-performance firewalls to secure their infrastructure. And fourth, we continue to benefit from market trends such as virtualization and network security mobility as well as the increases in network performance and bandwidth intensive applications that require high performance security in the enterprise and high-end environments. Overall we executed well in the first quarter and our financial results demonstrate this.

Let me now provide some high-level thoughts on the first quarter. In terms of some of the key numbers you can see them on slide number three. Billings were a $137 million, an increase of 28% year-to-year exceeding guidance of $122 million to $127 million. As a reminder we still, we bill worldwide in US dollars, so our billings and revenue are not impacted by FX fluctuations.

Revenues were $117 million, up 26% year to year exceeding our guidance of $112 million to $115 million. Non-GAAP operating income was $25.5 million up 27% year over year. Non-GAAP operating margin was 22% coming in at the high-end of guidance of 21% to 22% growth year to year. Non-GAAP EPS was $0.11 in line with our guidance. We had record free cash flow of $46.9 million up $10.4 million or 29% year-to-year. I would add that this is standard free cash flow as we reported in the past, it does adjust out excess tax benefits though our 1Q guidance included it.

And going forward we continue to provide guidance on standard free cash flow as many of you continue to ask for. Additionally at the end of Q1 we had over $600 million in cash, cash equivalents and investments and no debt. So to summarize we had a strong start to 2012 driven by a healthy security environment and demand for products combined with a solid execution and continued market share gains.

The investments in our global sales and R&D organizations continue to pay off and new product introductions position the company to maintaining our momentum for the remainder of the year. So now let me discuss our first quarter financial results in more detail. In terms of income statement Q1, billings were $137 million, which was an increase of $30 million, 28% compared to the same period last year continuing an accelerating trend. The strong service renewals in Q1 contributed to a $20 million increase in our deferred balance toward revenue balance.

Geographic breakdown of billings growth, Americas grew 30%, EMEA 23%, Asia Pac 35% compared to Q1 2011. All regions showed a strength including continued rebound in EMEA as we would be witnessing. In terms of product segmentation as you can see on slide 4, we saw a significant pickup in our mid-range enterprise products which accounted for 36% of product billings compared to 30% in Q1 last year. This growth was driven by several factors, including a very large regional customer deployment which included a high volume and mid-range products and extended service contracts. A larger amount of bundles of products in this category and market drafts of newly introduced FortiGate-300C, the 600C mid-range appliances.

If we exclude the impact of long-term 3-5 year bundles we saw in Q1, pure product segmentation would have been 34% entry-level, 31% mid-range, and 35% high-end and that's more comparable to prior periods. In terms of deal size, a number of large deals grew in all categories in Q1. Number of deals over 100K for Q1 was 153 and that compares to 111 in 1Q of last year.

Number of deals over 250 was 47, compared to 34 in 1Q of last year. Number of deals over half a million was 19 compared to 18 in Q1 of last year. Of the number of deals over 500,000, I want to point out these deals were larger as we had a large number of deals of 1 million more during the quarter.

In terms of buildings by key vertical, remember the last year we had been in the track approximate billings by top verticals, search provider, financial services, education, utility and government. These are our best guesstimates given we sell-through channel partners. So in terms of Q1 billings and I am just going to give Q1, Q1 billings per vertical, service provider was approximately 30%, government approximately 11%, retail approximately 12%, financial services 8%, education 6%.

Let me now transition from billings to revenue. Total revenue was 170 million as I noted up 26% year-to-year. Q1 ‘12 revenue metrics are on the same phase. We grew revenue growth as applied to 2011. If you look at product and services revenue together, they grew 30% year-over-year when you exclude the impact of the lower ratable revenue which continue -- which will continue to climb over time. That’s ratable revenue basically reduced our revenue growth by about 4%.

From geographic point of revenue, you can see those slides five and six. The revenue continues to be diversified globally, a key underlying strength of our business model. In Q1, we saw a healthy growth across all geographies, which enabled us to exceed our revenue targets.

The geographic split of revenue is calculated using the build-through address as was noted. In terms of Americas, revenue was 46.4 million versus 35.6 the prior year, an increase in 30% year-over-year. The key drivers for our strong performance in Americas were continued expansion within large enterprises, SMB sales to our channel partners and our overachievement again in Latin America.

During the quarter, we won several large deals with retail establishments for enterprise security deployments. There we continue to do very well. One noteworthy deal was seven-figure deal with a retail food chain to scale over 1,500 of its restaurants as well as its corporate office.

A broad UTM functionality, wireless access point support, and ability to comply well with PCI regulations helped us to win the deal. Another key win was with a Fortune 50 enterprise, one of the largest technology companies in the world. This was the first of multi-face cell security overhaul, including a corporate firewall refresh.

Functionality deployed include our next generation firewall, we beat our Check Point, Juniper too due to our superior performance advantage. And our recently formed healthcare vertical sales team also performed well and continued the fourth quarter results. Of particular note was the win with one of the largest healthcare providers in U.S. where we deployed our FortiGate appliances at several processes to secure the clients communications systems and protect their healthcare data as a part of a network upgrade project.

We beat out Cisco who was a network standard to win the security piece of the project due to high performance in Voice over IP support. In addition, I think it’s important to highlight that we continue to benefit from the multi-quarter rollout with a large retail chain, a Fortune 50 company, which is more than 8,000 locations across the U.S.

We mentioned this deal on Q3, ‘11 earnings call which was the largest deal in Fortinet’s history. Early during the quarter, our Latin American sales team won a seven-figure deal with a very large mobile phone service provider in South America to interconnect eight data centers. From superior security and ability to increase efficiency, productivity and uptime made the company to choose Fortinet over Check Point and Juniper.

Turning to EMEA, revenues 40.9 million versus 33.6 in 1Q of last year represented year-over-year increase of 22%. Despite the challenged economies of many regions, EMEA performed with continuous strength this quarter, performed exceptionally well with the U.K. and France showing particular strength.

We saw acceleration in billings in the region in addition to gain new customers; sales for installed base were also strong as evidenced by renewals. We continue to see strong demand for our integrated security solutions across among all-size customers in our high performance, low-end to next generation firewall solutions continue to drive wins with large enterprises.

The key win was a seven-figure deal with a U.K. government agency where we replaced an incumbent provider. This highly compare deal was won primarily because of our broad security functionality that possibly applies which will deploy in over 650 offices. We beat our number of competitors including Check Point, Juniper, Cisco, Palo Alto, and McAfee.

Another win was with a large credit card, a payment solution company in the Middle East, where we competed for the second phase of data center deployment. Our superior FortiGate firewall performance and virtualization capabilities along with our FortiWeb secure web gateway often enabled us to beat out Check Point and others.

Finally, we won a seven-figure with one of the largest telecom providers in the region which is currently building a large next generation data center of use for their entire network as well as new cloud services hosting, where we are up again Juniper's SRX line just like the Fortinet’s FortiGate system due to our superior price performance ratio, virtualization capabilities and ability to easily mask configuration changes.

Turning to Asia Pacific, revenue came in at $29.9 million, compared to $24 million in the same quarter prior year, up 25%. APAC again delivered solid growth particularly in Japan and Korea. Network and security consolidation are best in class, UTM offerings continue to drive business that led to several key deals in the region. Similar wins in Asia PAC included a multi-phase UTM deployment with a major public university with three campuses and 11,000 students. We won this deal once the customer decided to evaluate our solution after early inspecting installed networks and determined we offer superior security and performance.

Another win was a long-term project with one of the largest universe networks in Asia PAC which will be deploying our full UTM capabilities to more than 50 campuses over the next 12 to 18 months. We beat Palo Alto Networks, Juniper and Cisco by successfully demonstrating a superior performance, excellent feature set and UTM capabilities.

So now let me break out revenues between products and services. Product revenue was 53.2 million, up 32% a year-to-year. You can see slides seven for this break down. Product revenues are important leading indicators, strong Q1 increase bodes well for services growth over the next few quarters.

Product revenue in Q1 was driven by strong demand for our mid-range FortiGate-200B, 200C and 600C products to enterprise customers and branch deployments as well as acceptance of our new high-end FortiGate-1000C and spanning sales of our FortiGate-3950B with large enterprise customers. We also saw continued growth with our FortiWiFi and FortiAP wireless products and recently introduced low-end FortiGate products in terms of FortiGate-20C and 40C.

In terms of services, revenues came in at $62.1 million, up 28% compared to 48.7% quarter a year ago. Services revenues are expected to continue to grow overtime due to expanding installed base of customers which drives increase in our deferred revenue balance. Ratable revenue came in at $1.9 million and there is no additional continued decline overtime as we unitize the balance of our pre-2011 deferred revenue.

In terms of the headcount, you can see on slide eight, you can see that we ended Q1 with 1,655 employees compared to 1,583 in Q4 and 1,389 in Q1 of last year. We will continue to ramp our hiring efforts primarily in sales and R&D as well as support, to support the healthy growth we are seeing across all of our verticals and geographies. Net headcount grew 5% on a sequential basis and 19% year-over-year.

In terms of functionality, sales and R&D still account for approximately 130 with sales headcount well balanced across three main geographies. Service and support functions account for approximately 22% with G&A at 7% and operations at 2%.

If you now look at the, let me now turn quickly to the income statement across ratios. Our total non-GAAP gross margin was 74% in Q1, slightly lower than the same period last year and in line with the fourth quarter of 2011. Non-GAAP product gross margin was 64% for Q1 down a point from Q1 2011.

As a reminder, we typically see some variability as metrics putting up mix within product family, but we remain comfortable with non-GAAP product gross margins above 60%.

Non-GAAP services gross margin was 83% during Q1, down a point from last year and I want to point out that we are and we’ll continue to aggressively invest in our technical support staff to accommodate our expanding customer base and higher demands from our large enterprise customers.

We expect non-GAAP gross margins to remain within our target range. Total non-GAAP operating expenses were $61.5 million in Q1, up 23% year-over-year compared to revenue increase of 26% year-over-year. This increase was primarily driven by the increase in headcount to support our growth.

Sequentially, operating expenses increased approximately $5 million as a result of – and this is pretty much consistent with what you saw last year, where we have a pretty significant increase of expenses in Q4, the prior year in Q1 and due to the annual merit salary increases, increase in [PQ] accrual in Q1, lower usage in Q4, the annual reset of payroll tax in the US and similar payroll tax in Canada.

Payroll tax associated with stock option exercises, which I’ll talk a little bit more about later and we also had -- I already talked about that, some increase last year. So it’s about $5 million increase sequentially on few of those factors.

As a percentage of revenues, total non-GAAP operating expenses during Q1 were 52% compared to 54% for the same period last year and 47% during the fourth quarter of 2011.

Q1 non-GAAP R&D increased 27% year-over-year to $17.7 million and as a percentage revenues, our non-GAAP R&D was 15% which is comparable for last year and up from 12% from Q4.

In terms of sales and marketing, non-GAAP expenses increased 25% year-to-year at $38.6 million; as a percentage of revenues for both quarters it was 33%. Non-GAAP G&A, again investment class that 4% of revenues and $5.2 million compares to 6% last year.

In terms of profitability, non-GAAP operating income was $25.5 million and represented non-GAAP operating margin of 22% when compared to $20 million last year and 22% basically same operating margin for last year. This includes $2.1 million of payroll taxes which is way to stock option exercises and compared to $1.3 million Q1 of last year and I would add that this approximates about 2% of revenue that we incurred for payroll taxes due to stock option exercises.

Our other income increased $0.3 million in Q1 due to higher interest income. Non-GAAP net income was $17.5 million compared to $13.9 million last year, an increase of 26% year-over-year. Non-GAAP EPS $0.11 compared to $0.09 last year.

Diluted shares outstanding, 165.8 compared to 162.9; all these post stock split. As I mentioned in the beginning of the call, a full reconciliation to our non-GAAP and GAAP results in earnings press release and slide 14 and 15 of the presentation of the company’s prepared remarks. And so those non-GAAP preemptive measures are not described in the earnings press release.

Quickly in terms of GAAP numbers; GAAP net income was $14.2 million compared to $13.6 million in the first quarter of last year. The year-on-year GAAP net income growth was impacted by a little 4.2 million of stock based compensation and higher GAAP tax rate compared to Q1 of last year. GAAP tax expense were 28% compared to 25% last year. GAAP EPS, diluted EPS was nine versus eight.

If you look at balance sheet on slide 10, 11 and 12. In terms of cash and equivalents and investments, we ended the quarter with $67.3 million which creates about $3.02 per share. $62 million increase in Q1 was primarily due to $47 million of free cash flow generated in the quarter, plus $14 million of stock exercises in the SPP proceeds. Cash generated from operations was $48.5 million on a GAAP basis.

Few other highlights on the balance sheet. Revenue quality net AR decreased $10.8 million to $84.8 million from $95.5 million. DSOs were 65 days compared 69 prior year and we’re at the low end of our range of 65 to 70. Continued very good ageing credit quality and again demonstrates a high quality revenue overall.

Our inventory increased by 1.8 to 18 from 16.2 million in Q4 and I would also note that when comparing to cash flow statement the 3 million increase you see in cash flow also includes the purchasing of customer valuations. We have and we will continue to invest in inventory to support our growth. Our net inventory returns were 3.9 million compared to 4.4 million in Q4 and consistent with effectively we had last year.

Net PP&E went up a little bit more this quarter to $9.6 million compared to $8 million in Q4 due to additional test equipment and R&D and we continue deployment and sales of that equipment for the expansion of our business.

In terms of deferred revenue balance, now this is interesting, it increased to $314.6 million, up $48.5 million or 18% year-over-year and $19.7 million or 7% sequentially. Now service and support revenue increased $20.9 million and our short-term deferred revenue increased to $215.6 million, up 15% year-over-year and 9.6% versus Q4 and our long-term deferred revenues increased to $98 million up 25% year-over-year and up $10.1 million versus Q4 due to increase in larger deals of multi-year services contract that discussed before.

So to summarize, the first quarter was a good one to a year driven by helping network security environment with strong continued demand for our products combined with solid execution continue to market share gains. We saw acceleration in building across all three regions which is a good leading indicator of future business. We have strong revenue growth across the board in all three regions. We may continue to rebound with particular strength now in UK and France, Americas and Asia Pacific also performed well.

Investments in our global sales organization continue to pay-off with particular strength in the larger enterprise. Price deals grew both in number and overall size of deals year-over-year. We remain excited about our market opportunity and our new product interactions which we expect to result in further market share gains across all geographies.

I’ll discuss with you guys in more detail later, but first let me turn the call over to Ken to provide more color on the overall market, new product introductions and our competitive advantage.

Ken Xie

Thank you Ken and thanks to everyone for joining us on this call. The first quarter marked our strong start to the year for Fortinet with continued demand for our core products and growing market acceptance of our recently introduced products. As Ken noted we once again exceeded across all finance metrics including billings, revenue, profitability and cash flow. Our results show the investment we have made in our global sales and R&D organization are paying off. In addition to deliver innovative market leading products we are further penetrating key large enterprise across all regions and continue to grow our position in the high and the low end security market.

While business is being driven by continuous robustness in the network security market fueled by following trends, first the requirement for high-performance loan agency security is increasing, our custom developed FortiASICs and the FortiGate System enable us to deliver unmatched performance with recent onsite testing demonstrate on RSA confirming that Fortinet has the world's fastest firewall secure over 500-gig of real application traffic which is 3X faster than our competitors.

The processing power boost we got from FortiASIC and FortiGate system is a significant performance advantage and the prime reason why we are growing well in the large enterprise service provider market. Another trend is the integration of multiple security functioning to a single unified path form for ease of management and better security. Fortinet as a pioneer and a leader in this UTM space continues to lead and benefit in this trend. The UTM market is becoming one of the biggest and fastest growing segment in the network security space and Fortinet has continued to gain market share with our product and technologies.

Finally the trend is towards delivering cloud-based managed security service by telco is seen continually. Our FortiGate-5000 system delivered highest performance, better unified multi-functions, virtualizations and very good features set Fortinet apart from competition and enable us to win large deals with new and existing Telco and service provider customers. So one of the example is one in Q1 was a six-figure deal with existing customer who is one of the world's largest telecommunication provider. This telco is expanding its large Fortinet deployment and has in fact the FortiGate-5000 system and FortiManager and (inaudible) to serve as the technology platform to deliver new cloud and customer premise based management security service offering to a customer within the region in EMEA.

So during Q1 Fortinet made acquisition of (inaudible) commodity based neutral guard device which gave us technology and talent in the DDoS base. Early today we are now the first product resulting from this acquisition, the FortiDDoS-100A, 200A and 300A appliance which expand our network security performance and detect and protect against a DDoS attack. We will be expanding this product line with additional next generation DDoS product targeted for release in the second half of this year.

As I have said in the past, we are proud of our product and quality and so the product certification and test are important for addition in this market. So during Q1 we achieved a common criteria EAL4 for our FortiOS 4.0 operation system and now 16th consecutive VBSpam award.

Additionally our FortiGate-60C was awarded best UTM security appliance in SC Magazine 2011 Readers' Choice award. And FortiGate-5000 achieved award FortiOS as the firewall performance of more than 500-gig real traffic application, real application traffic in the test performance performed by the BreakingPoint lab. So Fortinet hold most certification than any other security vendor and we intend to keep and maintaining this position by delivering high quality and superior functionality that is validated through the (inaudible) certification.

So we have an exciting technology roadmap. With the new FortiASIC and our new FortiOS 5.0 operating system coming out later this year, that we believe would drive our competitive advantages in the way of performance and functionality even further. So this long with the healthy network security environment making us confident that our ability to continue to grow and gaining market shares. So now let me turn the call back to Ken Goldman who will give us the finance outlook for Q2 and the rest of the year.

Ken Goldman

Great. I will do this relatively quickly and you can see the guidance on slide number 13. Let me remind you that guidance does consist of forward-looking statements and keep in mind my earlier comments regarding such statements. Let me talk first to second quarter. It is expected to be in the range of $136 million to $140 million which at the midpoint represents growth of about 25% year-over-year. Total revenues expected in a range of about $123 million to $127 million which at the midpoint represents year-over-year growth of approximately 22%.

Gross margin is expected to be in the range of 73 % and 74 % as we continue to invest in our support organization as well as the expected higher mix of products, it takes into account the continued investment in our support organization as well as the expected higher mix of product with services revenues.

Non-GAAP operating margin is expected to be approximately 23%, up slightly from Q2 of last year given the investments in sales and R&D. We see some room from operating margin improvements later in the year which is reflected by our full-year operating margin guidance of approximately 24%. Non-GAAP earnings per share expected approximately $0.12 based on expected share count in the range of 166 million to 168 million.

Free cash flow of $35 million to $40 million as the Q1 AR balance is $11 million lower than the Q4 balance that we started with much a lower beginning AR balance and this does take in account the significant overachievement that we achieved in Q1. Pro forma tax rate of 34% up from 33% and again that's through the exploration of the R&D tax credit so far. In terms of the full year we are increasing our guidance for the full year based on the strength of our first quarter as well as a healthy business environment that we see at this time and thus to expect billings to be in the range of 580 million to 590 million, up from our prior guidance of 565 million to 575 million. At mid point puts us approximately 23% growth for the year based on expectation to further gain market share during 2012.

Total revenue would be in the range of $515 million to $530 million, up from $505 million to $520 million that we previously provided. This midpoint puts our growth rate at 21% for the year.

Gross margins would be in the range of 73% to 74% and operating margins will be around 24% for the year.

In terms of EPS, we expect it to be in the range of $0.49 to $0.53, up slightly from the $0.48 to $0.52 we gave prior and based on our expected weighted diluted share count of approximately 167 million to 170 million.

Free cash flow is expected to be in the range of $160 million to $170 million, although the range is the same, it is expected to be up by $10 million from our previous adjusted free cash flow guidance as we estimate the excess tax benefit impact to be approximately $10 million for the year and again we are not splitting that now.

So it’s important to note that we are still a little bit more in the quarter and to the year and as we have in the past we will continue to update you as we proceed through the year.

So with that, let me now turn the call over to the operator. We will take your questions and answers. We will give the answers to your questions.

Question-and-Answer Session

Operator

Thank you sir. (Operator Instructions) Our first question in the queue is Michael Turitz with Raymond James. Your line is now open. Please go ahead.

Michael Turitz - Raymond James

I got a couple of questions, one, I don't know if I missed it, but was there, where there one or several very large deals in the quarter?

Ken Goldman

No, I didn't talk about any particularly large, large deals. We did have a number of deals that I noted over a million, but with no specifically large deal that I noted.

Michael Turitz - Raymond James

Okay, so certainly nothing in the $10 million or more range?

Ken Goldman

I wish it.

Michael Turitz - Raymond James

And then just I would like to figure one of the current doings, if I recollected that or just kind of look at your -- just like the change in current deferred it seemed a little bit short in terms of growth rate, but as far as I can tell its also a tough comp, right?

Ken Goldman

Well, I don’t know, I look at it, I mean the deferred revenue obviously is a base line where do you cumulatively during last year as well; what I am really look at is the growth in billings which case in account the growth in deferred plus revenues so that’s how we get the billings.

Michael Turitz - Raymond James

And then just one question on that adjustment free cash flow or get off the free cash flow; you said that it’s $10 million more because you are not adjusting but was there an offset on amortization so, but also an offset to the delta there?

Ken Goldman

We kept the amortization the way we’ve always done in the past and so effectively the way we’re doing to free cash flow this quarter and going forward is exactly same as we have done prior to Q4, there is no change.

Michael Turitz - Raymond James

Okay. Great, thanks very much guys.

Ken Goldman

We listen to a number of analysts that’s out there to make it simpler and not do a lot of permutations if you will.

Operator

Thank you, sir. The next questionnaire in queue is Keith Weiss with Morgan Stanley. Your line is open.

Keith Weiss - Morgan Stanley

I was wondering if you could dove into the impact of those multi-year mid-range bundling or maybe just help us a little bit more what that’s about sort of how that firstly comes in the balance sheet and then a one follow-up?

Ken Goldman

Well, basically what happens is, in terms of -- two different things, one is when you do a new deal, it includes service and non-service and it may include one year, it may include multi-year and so the extent you do more deals with service contracts, you renew it for multiple-years. And so you tend you do renewals; our original deals with multiple years of services involved and across just one year, you have a great component of that which is rated to deferred, as opposed to upfront type revenue.

Keith Weiss - Morgan Stanley

And then on that slide, you noted or you did a, if you excluded that impact high end, did the high-end SKUs dealings would have been 35%, would there also be a comparable effect on the low-end SKUs?

Ken Goldman

I think we did it directly for all SKUs, so with comparable data and basically we did it, whereas we just look at hardware product revenue how it looked, and so you didn’t look at billings for the point of view of services, you just look at product revenue hardware revenue until it would look like the number that I showed you.

Keith Weiss - Morgan Stanley

And then on each of the hiring side, it looks like your hiring picked up; the rate of growth in headcount picked up a little bit, can you give us little visibility into where you guys think you are in terms of sales capacity, how comfortable you are and maybe some view on how you continue, how you see headcount ramp for throughout the remainder of this year?

Ken Goldman

I would say it this way; we do feel that collectively as a company, we are doing a better job of hiring overall. So whether it’s in sales or R&D, let me take R&D first. We think we have done a better job of, particularly where the bulk of our folks are in Canada, Vancouver and so forth. We’re doing a better job of hiring up there. Better job here as well. Sales, it’s no one region, it’s pretty much we are increasing across the board and again I think there we are much more well known, we’re placed to come too so to speak from the security point of view.

And so I think in general our hiring has improved in terms of our capability. To the capacity I always take as part of headcount we always estimate in terms of how much more we sell, I would say that we feel very good about the success of the sales force overall in terms of making their goals and we will continue to bring on more capacity if you will as the year unfolds. Ken wants to add some.

Ken Xie

In order to the recent trend for all the cloud, for all the bigger data center and how this also help us to grow in there -- I think we have much better performance products and this cloud trends and also the datacenters is really helping the business also.

Keith Weiss - Morgan Stanley

And secondly one last one, in Q1, I believe you had a transition in your user distributor, you brought on new distributor; any impact from that transition or does went relatively smoother?

Ken Goldman

We are in a new chase, I think this year we did have some changes if you are referring to last year, and as you know I pointed out the fact that we had as well in Southern Europe we had good growth in the UK as well and so we actually pointed out a lot of deal we had in the UK. So we are seeing improved results there; our team has come together and as I said last year we had to make -- we thought we had to make the adjustments in our organization to improve and that’s what we’ve been doing.

Operator

Thank you, sir. And our next questionnaire in queue is Rich Sherlund with Nomura. Your line is open. Please go ahead.

Rich Sherlund - Nomura

I would like a follow-up on the question of large deal; is there anything you can show that’s in the pipeline that looks at the magnitude that was adjusted previously in terms of very large build?

Ken Goldman

I am not sure Rick I can fully understand when you say adjusted I am not sure I followed that. We don't intend to talk too much about pipeline going forward other than how it impacts our, how we take into account that for our guidance.

Rich Sherlund - Nomura

Yeah, I guess I was just talking about $10 million deal or anything in the pipeline of that magnitude?

Ken Goldman

You know we don't tend to you know I don't think we have ever done a deal of that magnitude here. We did a one large contract which over a number of quarters will equal that kind of a number. But that's over a number of quarters as opposed to one quarter’s billings or revenues. And with that $10 million deal that it would affect one quarter in terms of end user customer.

Rich Sherlund - Nomura

Ken was that not this past quarter but that was done previously you are saying.

Ken Goldman

This was last year. That was this period last year.

Rich Sherlund - Nomura

Okay, and might we see something similar to that this year even though it's not you know one deal.

Ken Goldman

Nothing that I can really talk to at this point.

Rich Sherlund - Nomura

Okay, Ken just to come back to the short-term deferred revenues, I mean to the degree that you had such an outperformance in the total deferred number, is there any ability that you have to kind of decide how much business you are taking in, on the short term deferred side to kind of manage the growth of the business.

Ken Goldman

No, actually it's not really how you know how it's done I mean and even the fact that short term versus long term that is, it just happens to be the kind of business that we might get in a particular quarter, the types of contracts that we get and it's not something that happens per se at the end of the quarter. It's much more sensitive to the customers and their particular demand in any one quarter. There are certain retail customers that frankly do like the ability to walk in their pricing and their cost over a period of time and frankly they like to get the billings done so they can lock it in. So we will see some customers that prefer that but as I said before we’ve had some other quarters where long-term deferred hardly budged it out and so it is a little bit arbitrate, so I don’t want to get people excited at one quarter so it makes the trend because it sort of it goes by what happens in a particular quarter. I would also add that we tend to see some higher renewal opportunities in Q4 and Q1 and tend to scale back a little bit from a seasonality point of view in Q2 and Q3 and we take that in account in our billings projections.

Operator

Our next question in queue is Sterling Auty with JPMorgan. Your line is open, please go ahead.

Sterling Auty - JPMorgan

Strong billings results specially in light of what we heard from CheckPoint, looking at the mix, it looks like mid range was strong but I am kind of curious, was there any softness whatsoever maybe to start of the year in enterprise or do you think the demand was consistent?

Ken Goldman

Now, I think it was actually very consistent deal, we had a very strong enterprise business in Americas in Q1 in particular and so no I think the you know some times from the types of product we may sell from customer to customer can change, from a little enterprise and particularly to the extent that we have you know it can a little adjusted by the mix but longer term bundles, but if you look at the hardware and the deals that we originate during the quarter our enterprise was quite strong actually.

Ken Xie

He is actually right. The meter in the product, the 300C, 600C we introduced in Q3, Q4 last year, so this started to ramp up, so we are continuing to introduce the new product later this year.

Sterling Auty - JPMorgan

Okay. And then I heard the competitive win case studies, but given (inaudible) and registration for an IPO can you just talk about competitive landscape against them and may be then broaden it back out to the whole segment?

Ken Goldman

(Inaudible), I always come back to the overall point that our particular market is a growth market. There aren’t a ton of competitors. There are a few competitors there and I think overall, yes, we are overall gaining share but I don’t think, well always like you say this is not a zero submarket that we are in and so I am not going to say anything negative frankly about anybody at this point.

Ken Xie

On other side, I think as well we try to develop technology, the basic technology more targeted long term like from ASIC share from all this integrated module functioning of FortiOS and also we have much broad geographic coverage like all this three region and also more vertical coverage and I think that I believe is really the basic turnout. We develop, contrive this growth long term compared to just a few segment and also does some and try to boost the sales by like a lot of spending in some few area. The other thing really from all the analyst reports surely the UTM, the multi function, the market keeping, growing more fast and so we are really the pioneer in this space and the firewall IPS combined that is the called the next gen firewall at the subset. That's confirmed by a few, quite a few research firm.

So we do see this as a trend that integrate multi-function solution is really the customer see the benefit of it and so we feel we have a good platform, we can add additional performance beyond the CPU can do and also the multi function, we develop and integrate together, it is also being in the market for ten years, for more than ten years. So we see is a huge advantage we have.

Ken Goldman

I think in terms of actually the opposite of some of the questions I think you know we are benefited by the fact that we are not reliant on any one major deal like to a million dollar deal. In the quarter we have -- you know we ship thousands and thousands of units in the quarter to thousands of customers and so we are very well diversified geographically, both across the globe as well as each of the regions themselves, so we have a very broad based sales force, very, very broad based product portfolio and in some areas there and typically some of the midpoint areas that we do want to increase some shares, so it isn’t you know this is certainly again, pin or check or whatever but there is a whole host of opportunities up and down the board that we see we can grow.

Operator

Thank you sir. The next questionnaire in queue is Walter Pritchard with Citi, your line is open. Please go ahead.

Walter Pritchard - Citi

Ken Goldman I am wondering just on the trend around the long-term deferred, did you see that trend with longer-term contracts across all geographies and product lines or was that a fairly isolated trends with certain deals and certain types of contracts?

Ken Goldman

I am guessing a little bit on older America but that delivers I get lot of heads nodding in this room here so I think I am safe to say that but I don’t see the reason I am hesitating is that we don’t have that specific gain in front of me but when I think some of the things that caused I think it is primarily Americas.

Walter Pritchard - Citi

And was there something you did in terms of – you just in bundling, was it more of a pragmatic bundling or was it bundling on specific deals that drove that?

Ken Goldman

No what it is as I said before it relates to customers in particular a certain number of customers that prefer longer-term bundles because again and again it does not necessarily consistency in this, but in this particular quarter, they prefer -- we want some deals in which they prefer to do longer term, three, four or five-year kind of arrangements as opposed to just one year arrangements, and obviously to the extent you do that, you only take the upfront revenue for the product and all the rest of that bundle is deferred.

Walter Pritchard - Citi

Got it and then just, I just related it to your guidance, you raised it, you know your long-term was about 10 million more than you thought you raised the guidance for the year by about that or slightly more. Do you expect that that trend continues through the year or is that something that you think by your guidance going forward, you don't really try to forecast some trend?

Ken Goldman

Yeah, I don’t want -- I always said I don't want to get ahead of myself. So or ourselves I should say. And so, you know, what we did is we basically took Q1, took that outperformance, extended it out and you know, I think it’s still early in the quarter. You know, we are watching our business but we are also trying to gauge the environment that we are in and where other competitors are seeing and so forth, and so this is the best field we have at this point in time.

Walter Pritchard - Citi

Great, and then just one for Ken Xie, around the competitor landscape, you know, Cisco, the one maybe you touched on but they have reported that their security business is now growing, I guess, double-digit the last few quarters. I am wondering if you've seen any change as they are the largest players in this space.

Ken Xie

I think Cisco, the way they kind of measure maybe it changed to non-wire, consisting in a security space. So we don't have a much detail but some other feedback we got from a field or some analyst really, the way they measure probably is different. So, I think overall the feedback is really their security has been kind of flat.

Operator

Thank you. Our next question in the queue is from Erik Suppiger with JMP Securities. Please go ahead. Your line is now open.

Erik Suppiger - JMP Securities

First off, on the free cash flow, if I look at your fiscal ‘12 outlook, you are projecting basically down -- the future quarters are down from the Q1. What would cause free cash flow to decline from these levels?

Ken Goldman

Well, a couple of this. One is, you know, we exhibited roughly a similar pattern last year. Again, you get the improvement in Q1 from the ability to work office you will, the AR balance and particularly this year, you know we had a reduction in DSO, I think, three-four days from Q4. And it was accounted for 11 million decrease in AR. We’re assuming AR over the rest of the year will be going up and so that will be a source of cash. And that’s probably the primary driver over and above everything else because you know, if you look at pre-tax income, you know that’s goes up but not dramatically. So the AR can really drive a lot of our balance in terms of our numbers. So that’s how we see it. Historically, Q1 is a good quarter for us from a cash flow point of view.

Erik Suppiger - JMP Securities

Okay. So the idea that it comes down in Q2 and then it starts gradually growing from there to the second half?

Ken Goldman

Yeah, hopefully.

Erik Suppiger - JMP Securities

Okay. Secondly, Dell’s announcement to acquire SonicWall. Does that make any difference to you from a channel perspective or has there been any implication there?

Ken Xie

I think Dell’s probably has a little conflict with some of the channel partner in the DMR space, the direct market retail space. So that’s probably some of the channel gave us a feedback. I think it’s still early to say but it is, probably, sometimes that a dedicated security company becomes a part of the larger wider network company. Sometimes, they may slow down on the product innovation, or some other focus in the security space.

Erik Suppiger - JMP Securities

Okay. And then on the OS, I think it is 5.0 and the new A6. When will those be released? You said later this year. Is it any more clarity on when those will be released and when they might start generating revenue ramp?

Ken Xie

I think that’s for us really and we like a straight four years, we have a new major FortiOS release. So it’s time pretty much towards the second half of this year, and so that’s what OS is really. But we don’t generate revenue from FortiOS operating system, FortiGate system, that the FortiOS running on. That’s probably the product we’re selling. I don’t see that will have much impact on other side. Every quarter we release kind of a new FortiGate system, keeping the refresh upgrade. So that’s where the system, just like any other network device, after about, I think, four-five years you need to have the new generation which is faster, which also kind of have a better technology to put in there.

It is the same scene for the FortiASIC. So we have three FortiASIC families. 100 Quantum Processor, the other 100 a network processor in there and also the system chip. So that’s where --It takes average about two year to build a chip. So that’s where the FortiASIC chip will be starting built in the new FortiGate system later this year.

Erik Suppiger - JMP Securities

Okay. And the ASIC, is that in tandem with the new OS?

Ken Xie

I don’t think it is much related because FortiASIC is gradually working with FortiGate System. So FortiASIC probably, honestly the benefit after we release the FortiGate system and the FortiOS is really the function can be upgraded to all the current FortiGate if the customer bought a service. So it’s a free upgrade for the customers if they subscribe the service or this is -- So, its two different differences.

Operator

Our next questionnaire in queue is Brent Thill with UBS. Please go ahead. Your line is open.

Brent Thill - UBS

Just the third quarter in a row, your billings has accelerated and your guidance looks pretty strong for the second quarter as well. I am just curious, it seems like there is a combination of factors but if you kind of short list it in terms of what you are seeing that’s that you think is contributing to what’s happening here and put anything in context for us?

Ken Goldman

Fair comment. I will give you some thoughts and sure Ken will have his thought as well. But I think we are getting the benefit of a very stable sales organization that continues to sell a greater and broader product portfolio. And so I think, one of the things I am saying that I think others aren’t necessarily doing. We are trying to keep things as stable, consistent as possible, whether as we marginally increase our products. As Ken noted, we acquired companies but we do a pretty good job of slowly integrating them into the sales force. We manage the quarter achievement and I thought -- I think in a thoughtful way. And our markets overall are healthy such that you have more and more customers that understand the benefits of UTM, and I think some trends are going in our favor, related to UTM, and related to mobility, related to virtualization, and the brand awareness of Fortinet even though it’s not where we would like to be in. It continues to improve. So, I think we have lot of those things in which we are keeping things stable and consistent as possible and adding on as oppose to taking a detour. That that’s how I see it anyway.

Ken Xie

Yeah, I think its probably three major areas, the first is really our internal execution, hiring now and it just seems I think we keep improving. The second part is really related to the big market environment, I think the security space, right now the security space really keeping growing and it’s our healthy space and I think its overall because all this new trend whether it go the cloud or the mobile device, or bring your own device to work environment and they demand more network security and so that's basically the big environment also are healthy.

And the third part really, the long-term focus to develop some basic technology whether from a chip level, from OS level, from other function level and also the way we maintain the quality by (inaudible), so that's what starting to pay off and that's also what's keeping investment in this area.

So I think it’s always a sweet trend and is kind of helping us keeping growing for us really, we want to focus more long-term if that particular space or some function and try to boost by some kind of opportunity. But really keeping investing, growing long-term and eventually we want to make some difference in the space.

Brent Thill - UBS

Real quick on Check Point with the 61000 series they launched last summer, have you seen it show up and you could keep it to a simply yes or no?

Ken Xie

I think that’s the product probably more towards the server market, but I feel still its a little bit different approach than we have. We feel the level of security really need to design from a network point of view from the chip with the system level is that just leverage the CPU to server. And I think it’s a good product, but on the other side for us we still feel we need to launch more long-term investment on the basic technology to have the future much better product going forward.

Operator

Thank you, sir. The next questionnaire in queue is Robert Breza with RBC Capital Markets. Your line is now. Open please go ahead.

Robert Breza - RBC Capital Markets

Hi, most of my questions have been an answered, but I guess Ken Goldman could you talk a little bit about some of the vertical contribution you mentioned retailers as a key vertical, so were there any other verticals that did out this quarter?

Ken Goldman

Yeah, I think service provider, if you look at the percentage was on the higher end and what we’ve been saying. I think education, I pointed out a few educational wins and there is other I can’t think at the top of my head as well. So I think we are doing well in the education, so I think you look at service provider, you look at retail and I think about education some of the areas that I would point that we particularly commented this quarter.

Robert Breza - RBC Capital Markets

Maybe as a follow-up for Ken Xie; Ken have seen any change from a deployment perspective across the different verticals; are people starting to quarantine off their network or more; I am just curious to see if you’re seeing people change kind of the design of their network do you think? Thanks.

Ken Xie

I think under the price environment probably starting revisiting how they went to secure a lot of our whether mobile device or some other thing to go to the cloud, so that’s probably because some high-speed and also a multi-function device. And also we’re also trying to kind of simplify the security management because otherwise they have to deal with many different vendor and it is also sometime can be too costly or kind of too difficult to manage.

Other than that and also since internet started growth kind of pretty much everything using leverage internet and our application also kind of go over internet, we also see some kind of demand in our SMB and also in the emerging area like APAC, so you can see the APAC region also growing pretty fast in the last quarter. So we see a lot of new deployment going on there, lot of new inputs going on there. So that’s probably a few things we see.

Operator

Thank you, sir. The next questionnaire in queue is Jonathan Ho with William Blair. Your line is open.

Jonathan Ho - William Blair

I just wanted to start-out with may be the datacenter space, are you seeing sort of an acceleration in terms of opportunities for a security there or any change in terms of that opportunity?

Ken Xie

Yes, I think that a lot of datacenter being build right now because all these due to the cloud, out of service based approach. But initial skill that the secured gateway seemed much, much slower than the networks which can deliver in the datacenter probably even 10 times lower because we think it’s really security gateway process much more. They need much more processing power because they had to go deeply in the pack of audience, competent audience switching to deliver the trophy there.

So that’s where today, with still a lot of our low percentage datacenter has any kind of security on the network side, so that’s obviously a huge gap, that’s making kind of network security interesting is really a lot of huge datacenters do too fast for a secured device to even secure it right now; it’s still quite a low percentage and that the space deal are huge.

Jonathan Ho - William Blair

And just in terms of your vertical strategy, I mean you guys touched a little bit on that but I just want to understand you know how much of a difference is that making as you are targeting the specific vertical does this accelerating your growth or helped your win rates; just trying to quantify or understand you know how much of a difference that’s making?

Ken Xie

We do see a service provider going well because that’s we are starting using value added service and even some other parts leverage service provider to security offering there. In other new area I think that’s probably as we have mentioned in the past one or two years, we’re starting to divide cells into the vertical space like Ken Goldman mentioned early, so we’re starting to build healthcare team and the finance service vertical space and the education space.

So that does start paying off because some time these vertical space deals take a little longer time compared to early days we have more regional based sales force. So that also drive us to the bigger deal, so that’s the area we see kind of gradually gave us more kind of bigger deal there. On the other side is really I mentioned some of the international region APAC or some other and you will be studying how we have good recovery there and also APAC we are starting to see some good growth there.

Jonathan Ho - William Blair

And just one follow-up if I may how does the common criteria certification expand maybe your government opportunity open-up some doors for you guys?

Ken Xie

We just want to set high standard and make sure to quote out ever since really for the highest quality, we are going to hear about but also ISO Certification and some other certifications we have; not only the company, not only benefit government, but some other big enterprise, some other government outside US also from time-to-time to use as a standard to measure different vendors. So first like we say, we maintain the highest number of certification among all these major security vendors. So we want to continue to invest in this area because it's difficult for various enterprise or some, even some government or some other customer to test how secure each vendor's product is. So that's where the third party certification is the best way to validate instead of each vendor try to market, over market to promote themselves.

So that's where the third party certification we view as a way to maintain our high quality and that's where each function we try to go all the major certification in that particular space whether it's firewall, antivirus or intrusion or antispam and at the same time and others like ISO, the (inaudible) and SIP's certification and also the [NAPS] navigation with telco, I think we maintain a lot of certification and thus try to keep a high quality for the product.

Operator

Next questionnaire in queue is Aaron Schwartz with Jefferies.

Aaron Schwartz - Jefferies

Good afternoon and congratulations, I just had a question on these retail deals, I know you had a big one in Q3 and another one here, you know it seems like you have a nice little sort of franchise in that area and maybe because your broad based product portfolio is well as suited for the large deployment there, but can you just talk about sort of how that deployment works, I mean are these you know four quarter deployments or maybe it's not standard but maybe you could just walk us through how that works.

Ken Xie

There's one in particular that we did refer to instead, we won in Q3 of last year which is a large one. That was developed in a way to roll it out over a number of quarters, four quarters or whatever. There are some other ones that sometimes they will do in phases, Phase 1, 2, 3, other times it's you know, it’s a one time, I mean it is initial one-time agreement and then they may buy down the road but there is no commitment upfront as to doing that so. It varies all over the map to the point I mean to the extent where they may do a committed phased rollout to the extent there is a one time but with the idea that we can win future business along the way.

Aaron Schwartz - Jefferies

But the billing work per deployment so as you bill it out on a multi-quarter basis, it's just billed on you know basically a per unit basis?

Ken Xie

Yeah as a fact we had in, the extent that we’ve bill that means we bill, we invoice, we collect and we only count the billing if it's collectible within our normal payment terms and so to the extent that we have a contract over a number of quarters but we can’t, but we can only bill say the first quarter that would be what we count for billings for particular quarter.

Aaron Schwartz - Jefferies

Okay. And then second question from me if I could, on the long-term deferred I mean that you alluded to some multi-year, three, four, five years deals there. Do you collect all the cash out front on those?

Ken Xie

Well yes. If again if it’s a billing that includes a number of years we would not count the billing unless required the cash up front that's correct.

Aaron Schwartz - Jefferies

Okay. So everything in long-term deferred, that’s all.

Ken Xie

It's all invoiceable and collectible.

Operator

Next questionnaire in queue is Scott Zeller with Needham & Company. Your line is open, your question please.

Scott Zeller - Needham & Company

Hi, thanks. Just going back to an earlier question for clarification. If we look at page four the slide deck, when you talk about the high end billings contribution, that 31% would be 35%, if we only focused on actual license product sales, is that correct.

Ken Goldman

Yeah. If you just look really at hardware.

Scott Zeller - Needham & Company

Just the hardware.

Ken Goldman

Right.

Scott Zeller - Needham & Company

And also regarding the high end again could you talk, we’ve had some earlier questions about competition, but could you talk specifically about the largest carriers, the carrier grade products and who you see competitively there and if there has been a change at all?

Ken Goldman

Yeah. I am looking and I don’t think we have seen a significant change in the competitive landscape on service grades. I think that's the business that we continue to as far as we know when the majority share of the business and I think there is a case particularly if you are talking about them as a service provider, manage the security service provider where the UTM product feature really fits their need and so I think there is really no one else that has the ability to really service that to the extent that we do.

Ken Xie

I think for a service provider the three major functions they need, first is the high performance reliability. So that’s also both south region of in the higher platform. So that we have a huge advantage with our customer design ASIC system which is much more reliable compared to some other as a PC server in the higher base and also the NIPS certification, that's where (inaudible) also helps there. The certain part is really, really for the flexibility functionality because for the service provider, so they need to have the flexibility to offer different functions to different customers. And that’s where we have 11 function in the UTM. So in the same box they can turn on, turn of different function based on the customer need and then the third major piece is really the virtualization function.

So basically you can have a one system to manage hundred to thousand different customer, each look like they are owner, they own a system themselves. That’s a virtualization we started shipping since 2004. So we are way ahead of any other competitor. This is a sweet major advantage to make us love our good position in this ethical service provider market and so far we don’t see any competitor come close to what we have.

Operator

And next questionnaire in queue is Jayson Noland with Robert Baird. Please go.

Jayson Noland - Robert Baird

Thank you and good quarter and mostly follow up questions here. On [D5] and new ASIC, do you guys expect to see any seasonality in the revenue in the back half of this year?

Ken Xie

So far, usually it takes some time especially if you look under, there is a sweet layer since first at the chip level, the FortiASIC and then it is a top layer with the FortiOS, but what is important really the FortiGate in the medium level, so that’s why every quarter we release one or two or three new FortiGate system now reached the better ASIC or better CPU or better other since there. But for us from our historic data we don’t see kind of up and down once we release whether the new ASIC or the OS and it's kind of a – it's more long-term benefit inside the short term like a benefit in a particular quarter.

Ken Goldman

Yeah I think I pointed out is the ASICs tend to get incorporated into the newer products overtime so it is not like a one-time event in which all parts have a new ASIC, that’s one thing. Two is we have a natural progression of new products that we introduce every quarter and so we are not necessarily dependant upon on anyone product. It is the same for operating systems, so we tend not to have the up and down cyclical that you have with bringing out new products and which customers held up and wait for new products, it does not tend to be the way it works here overtime.

Jayson Noland - Robert Baird

So okay and thank you and I wanted to follow up on Cisco also, they made a push at RSA and even at their Partners Summit last week and Ken Xie, you said you don’t think they are growing per the industry data but have you noticed anything in the field where they have gotten more aggressive or roadmaps that have made deals more challenging at all?

Ken Xie

We don't see much. On either side, we have kind of probably less compete was Cisco because they are a big networking company, secured as a part always, they are offering some part on the whole deployment, so we don't compete much with Cisco and also we don't see much change in the space.

Jayson Noland - Robert Baird

And then last question from me, any update on sales and marketing investment, you talked about that before and it looks like that came up nicely in Q1, the investment level in sales and marketing specifically?

Ken Goldman

Yeah, still primarily in sales; I think we are still working as to how we can smartly increase some of our marketing spending as well, but we did add a number of folks in the sales side and that could increase the sales costs.

Jayson Noland - Robert Baird

You happy with the progress there?

Ken Goldman

Yeah I am actually, I think if I look at, in this case I will use the pipeline term, if I look at the folks we targeted as well, with the pipeline that new people we are in process of acquiring, it looks pretty strong and so yeah I think there again as I compare us and I say we are trying to keep things very consistent here in terms of how we attract to retain and motivate the sales organization and I think its working. We have overall a very stable team and we continue to add to it. So I think if anything our ability to hire is better today than it has been.

Operator

Thank you, sir. And our next questionnaire in queue is Phil Rueppel with Wells Fargo Securities. Please go ahead. Your line is now open.

Phil Rueppel - Wells Fargo Securities

Just a quick one, one of the top verticals kind of remain government and that is one area where we’ve been hearing you know concerns over the spending environment. Are you seeing more budget pressure from the customers in government and do you think you’re still -- are you getting share in that segment similar to some of the other verticals?

Ken Goldman

Yeah, I would say we’re not gaining share in the federal government that is historically not been a strength for us, you know I don’t think we therefore is impacted positively or negatively by the budgetary issues there, but in general you know that’s nearly for us still very modest in terms of results. So when I give overall government result that you see, a small portion of that is federal, a bigger portion is really globally the government business.

Operator

Thank you, sir. Next questionnaire in queue is Brian Freed with Wunderlich Securities. Please go ahead. Your line is open.

Brian Freed - Wunderlich Securities

Two quick follow-ups; first, you had a 34% tax rate in the quarter you mentioned R&D tax credit. Can you talk about where you expect that go moving forward? And secondly, you talked about operating leverage incremental in the second half. Can you talk a little bit about what elements of your cost sales R&D gross margin offer the most leverage? Thank you.

Ken Goldman

Yeah, from a cash point of view right now we’re hanging at 34% and we don’t actually like that rate, but it does take into account the lack of R&D credit and we don’t really have as of yet anything that could bring the rate down. We are working on some new organizational structures if you will that might have a mass impact towards the end of the year, but hopefully we’ll have a bigger impact as we get into ’13.

In terms leverage, I think gave guidance on gross margin, so I think I have talked to that. I think with leverages, as we grow the business we intended during the year, not to be higher as much in R&D, so I think we will get a little bit of point there and I also expect us to see some leverage in the sales side. It was 33% I believe this quarter and we tend to get down to 31%, 32% as the year unfolds. So I think a little bit both in sales, a little bit in R&D, but nothing dramatic. That would get you from the 21, 22 times of numbers to 24, 25-ish.

Operator

Thank you. (Operator Instructions) Next questionnaire in queue is Alan Weinfeld with Davis Securities. Please go ahead. Your line is now open.

Alan Weinfeld - Davis Securities

Thanks guys.

Operator

Mr. Weinfeld, your line is open. Please check the mute button on your phone.

Ken Goldman

Alan, can you hear us okay Alan? Alan, we can’t hear you. We can go to next and Alan can then comeback in or briefly we’ll be here at 03:30 Pacific, we will be right for next – people can ask questions then too.

Operator

Okay. We do have one additional questionnaire in the queue at this time then?

Ken Goldman

Well, we will have as a last question and then we will hold to 03:30 Pacific, how is that?

Operator

Understood sir. Mr. (inaudible) please go ahead. Your line is now open.

Unidentified Analyst

Sure, Ken hi, I thought you were going to keep the party going till 03:35?

Ken Goldman

We got a party, but that’s the way you want to use us great.

Unidentified Analyst

Hey, I guess I just want to follow-up on the, on gross margin guidance that you lowered the range to 73%, 74% versus prior year 74% I ma just curios if it was a mix issue there, if new products have lower yield or nothing specific in mind to your best just simply given yourself more room with the specific in line?

Ken Goldman

There are a couple of things I have in mind, I mean as we really expand the customer base, we are having to increase our support efforts, and so it’s a little bit of a catch up there, and so that’s an area of investment as well. And so we do expect a little bit of a mix shift between products and services to the extent that drove more products and services and that also affects the gross margin.

And I think as we brought out, as we noticed the more mid-range products and the mid-range products tend to have a little bit less gross margin than we see on the higher-end products and as the year, the very end of year we often expect to bring up more higher-end products that may help. So frankly it’s a modest change in terms of gross margin, but there are a few factors that I think are important to point out that I do see that progress in gross margin maybe to go down a point as opposed to increasing a point.

Unidentified Analyst

Great, thanks.

Ken Goldman

So why don’t we hold out there; we will close out this party as was called and in about 35 minutes we’ll re-engage for additional questions that you may have thought of to call. So I thank you for bearing with us. We have a lot to cover and we appreciate your time and we will be here in 35 minutes to continue on and so again, thank you.

Operator

Thank you. Again, ladies and gentlemen, this does conclude this session. You may all disconnect and have a wonderful day.

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