Fortinet's (FTNT) CEO Ken Xie on Q4 2016 Results - Earnings Call Transcript

| About: Fortinet, Inc. (FTNT)
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Fortinet, Inc. (NASDAQ:FTNT) Q4 2016 Results Earnings Conference Call February 2, 2017 4:30 PM ET

Executives

Kelly Blough - VP, IR

Ken Xie - Founder, Chairman, and CEO

Drew Del Matto - CFO

Analysts

Gabriela Borges - Goldman Sachs

Sterling Auty - JP Morgan

Melissa Gorham - Morgan Stanley

Saket Kalia - Barclays Capital

Shaul Eyal - Oppenheimer

Gregg Moskowitz - Cowen & Co.

Michael Turits - Raymond James

Jonathan Ho - William Blair

Catharine Trebnick - Dougherty

Hendi Susanto - Gabelli & Company

John Lucia - JMP Securities

Taz Koujalgi - Deutsche Bank

Mike Feldman - Bank of America

Fenn Hoffman - Evercore ISI

Operator

Good day ladies and gentlemen and welcome to the Fortinet Q4 2016 Earnings Announcement Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instruction will follow at that time. [Operator Instructions] As a reminder, this conference is being recorded.

I would now like to introduce your host for today’s conference to Ms. Kelly Blough, Vice President of Investor Relations. You may begin.

Kelly Blough

Thank you, Vicky. Good afternoon and thank you everyone for joining us on this conference call to discuss Fortinet’s financial results for the fourth quarter of 2016. With me today are Ken Xie, Fortinet’s Founder, Chairman, and CEO; and Drew Del Matto, CFO. Ken will begin our call by providing a high-level business perspective. Drew will then review our financial and operating results and conclude with our forward guidance outlook before opening up the call for questions.

During Q&A on this call, please plan to limit yourself to one question only with no follow-up. As a reminder, today we’re holding two calls. For those who have additional questions, we will hold a second conference call at 3.30 pm Pacific Time. Both calls will be webcast from our investor relations website.

Before we begin, let me first read this disclaimer. Please note that some comments we make today are forward-looking statements. These forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those projected in these statements.

Please refer to our SEC filings, in particular the risk factors on our most recent Form 10-K and Form 10-Q for more information. All forward-looking statements reflect our opinions only as of the date of this presentation, and we undertake no obligation and specifically disclaim any obligation to update forward-looking statements.

Also, please note that we will be discussing certain non-GAAP financial measures on this call. Our GAAP results and GAAP to non-GAAP reconciliations can be found in our earnings press release and on slides 12 through 15 of the presentation that accompanies today’s remarks. Please refer to the investor relations section of our website at investor.fortinet.com for important information, including our earnings press release issued a few minutes ago and the slides that accompany today’s prepared remarks.

A replay of this call will also be available on our website. Note that we routinely post information on our website, and we encourage you to make use of that resource.

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

Ken Xie

Thank you, Kelly. And thanks to everyone for joining today’s call to discuss our fourth quarter and fiscal year 2016 results. In the fourth quarter, Fortinet delivered a billing revenue growth that exceeded our guidance range. We benefited from our focused effort to improve sales productivity and expense management and are well on track. So, we have more work to do, but are pleased with the progress we have made and with the performance in the fourth quarter.

As customers move forward to consolidation and a seamless tightly integrated approach to security, we’re seeing a sharp increase in the adoption of Fortinet Security Fabric architecture. Our ability to provide a broad, powerful, and automated Security Fabric that protects all points in the network, from IoT to cloud, physical and virtual networks, wired and wireless environment set Fortinet apart.

Our competitors multiple-point products and platform solutions simply are not capable of providing the broad solution, processing performance and the advance automation necessary to address the demand of today’s digital economy. As we continue learn and expand into some of the largest enterprise corporations and the government organizations in the world, we added more than 10,000 new customers during the quarter. This brings a total to more than 300,000 customers worldwide. Boarder adoption of our Security Fabric also results in increased of sales of enterprise security services and of numerous [ph] FortiGate solutions.

The Internet of Things and cloud computing are key technology drivers of the digital economy. Every day, over 1 million new IoT devices are being connected to the internet. The recent massive IoT based DDoS attack showed how vulnerable this device can be. Keeping up with IoT requires internet based network security. Internet based network security automatically translates in its requirement into synchronized network security actions without human intervention; Fortinet has laid the foundation for the internet based network security with its Security Fabric architecture.

Our strong technology advantages also uniquely positions us for effectively deliver security to the cloud and for the cloud. We’re securing public cloud through strong partnership with Microsoft Azure and AWS. Sales of our cloud related products and services across public, private and hybrid cloud continue to grow faster than other part of our business.

Today, we announced expansion of our high-end FortiGate enterprise firewall for service provider and enterprise customers. The FortiGate 7060E and 3980E. The FortiGate 7060E is the world’s fastest next generation of firewall and most powerful addition to our product line. And integrate our new CP9 security processor with significant advance in hardware design, system performance and stability to deliver high security performance in the industry.

The FortiGate 3980E is the world’s first terabit per second network security appliance. It is ideal for enterprises that need very high network throughput and a deep inspection delivered in a compact appliance. The FortiGate product also been approved by the Defense Department’s top service security authority as a solution for classified network, validating that Fortinet delivers the performance and scale that [indiscernible] need for complete security assurance solution.

Finally, we just returned from a Worldwide Sales and Global Partner Conference with more than 2,000 attendees. The enthusiasm among employee, partner, customer has never been stronger. With our Security Fabric, we deliver broad, powerful and automatic security solutions spanning end point, access, network, application and cloud. We’re one of the few network security vendors that continue to outpace the market. Looking ahead, we’ll continue to innovate and invest to further differentiate and provide our customer with a comprehensive threat protection they need today and for the future.

I would now turn the call to Drew to review our fourth quarter and fiscal year 2016 financial results and forward guidance.

Drew Del Matto

Thank you, Ken. Let me now share our financial results for the fourth quarter, which can be seen on slide three. Fortinet had a strong end to 2016 with billings, revenue, margins, and non-GAAP earnings, all exceeding the high end of our guidance ranges.

Fortinet’s billings increased 22% year-over-year to $463 million. Total revenue of $363 million was also up 22% year-over-year. The outperformance in top line growth was driven by seasonal demand, improvements in sales productivity, and success in selling multiple product deployments, demonstrating adoption of the Fortinet’s Security Fabric architecture.

Deferred revenue increased to $1.35 billion, up 31% year-over-year. The growth trend in deferred revenue has become more pronounced as our mix of business shifts to more margin-rich recurring subscription and service revenue. Sales of enterprise bundles nearly doubled quarter-over-quarter, which drives recurring, higher margin revenue over time, and increases customer lifetime value. We delivered strong non-GAAP gross margin of 76%, exceeding our guidance of 74%. Our focus on driving sales of higher value, higher price and higher margin recurring revenue streams such as services and virtualized product offerings, helped improve gross margins in the quarter.

From a profitability perspective, non-GAAP operating margin and non-GAAP earnings per share were 22% and $0.30, respectively. These are both well above the high end of our guidance ranges. Organizational discipline combined with improvements in sales achievement contributed to the operating leverage we delivered in the quarter. Our continued focus on expense management and sales productivity will keep us on course to reach our previously stated goal of 20% non-GAAP operating margins on an annual basis, exiting 2020. Finally, we generated $84 million of free cash flow during the quarter, an increase of 40% over the fourth quarter of 2015.

While we’re pleased with our fourth quarter results, we recognize that we have more work to do to make our investments in sales and marketing fully productive. And we remain focused on continuing to execute our plans. Further, we continue to keep a close eye on expenses to ensure operational efficiency is an ongoing driver of profitability. In addition to these improvements, we believe margins will benefit from the continued shift to services, cloud and virtual solutions such as FortiSIEM.

As Ken mentioned, Fortinet’s strong technology advantage enables us to benefit from key secular trends such as security vendor consolidation, segmentation, IoT and the move to the cloud which necessitates increased level of visibility and security orchestration.

Fortinet Security Fabric weaves together our market-leading product, advanced services and partnerships to provide seamless protection, industry-leading performance and excellent visibility and security orchestration at all points in the network from IoT and more traditional end points to data center, to cloud in virtual, physical and hybrid environments. This is a strategic and important consideration for our customers as they move from the limited capabilities of point products and away from incumbent, lacking the necessary innovation or integration capabilities that are Fortinet’s hallmark.

We expect this consolidation trend to continue as a business driver for Fortinet and to drive multiproduct deals as customers adopt the Fortinet Security Fabric to protect their entire infrastructure. This adoption of the Fortinet Security Fabric is driving more business as evidenced in Q4 2016 by sales of non-FortiGate products. Growth in these product lines significantly outpaced our FortiGate products with significant growth coming from FortiSandbox ATP products. We also saw more deals that included multiple Fortinet products in physical, virtual and cloud environments.

As an example, of this type of multiproduct integrated adoption of the fabric, in the fourth quarter, a large financial services company signed a contract to expand its Fortinet deployment. Having rolled out Fortinet solutions at all of its branch locations, this customer purchased the mixture of FortiGate 3200D, 1500D, and 600D bundles in the fourth quarter to replace an existing vendor in their data center. This also included FortiManager VM, FortiAnalyzer VM and enterprise services.

Also in the fourth quarter, a large government ministry in the Middle East chose Fortinet to replace their entire existing solution with one integrated platform. In a competitive bake-off, Fortinet was chosen for our ability to provide an expansive tightly integrated fabric and displaced at least four existing vendor. This deal included numerous FortiGate, FortiMail, FortiATP and FortiClient products along with our enterprise subscription bundle. Additionally, a leading university in Europe with an extensive partner in campus networks chose Fortinet to provide a fully managed UTM service.

As Ken said, our cloud solutions are a critical component of the Fortinet Security Fabric and represent a significant expansion opportunity and long term driver of our growth. Fortinet delivers security to the cloud and for the cloud. We support all major cloud deployment scenarios whether public or private. This provides customers the ability to choose and migrate where and when they need. We partnered with Amazon, Microsoft Azure, and others to offer variety of deployment choices, a common operating system and the management platform across IoT to cloud. The flexibility and performance of the Fortinet Security Fabric and the visibility and security orchestration advantages that it provides, put us in a strong competitive position in the early days of cloud adoption. And we’re winning deals and partnering with customers as they architect their next generation infrastructures.

Our cloud and virtual business more than doubled year-over-year in the fourth quarter. Although, this was from a small base, it continues to represent the fastest growing segment of our total business. This segment of the business will provide yet another high margin recurring revenue stream that contributes to future business growth, predictability and profitability.

Some example of key cloud deployments and expansion in the fourth quarter including a contract with a large UK government agency to deploy FortiGate in a high availability design. This is part of a government initiative to migrate a majority of on-premise functions to the AWS cloud. The deal expanded upon prior Fortinet virtual machine and AWS with an on-demand model. In another example of cloud deployment, Fortinet signed a deal with a large global cable company to deploy FortiGate in a high availability design. Rolling this out to notable, global AWS market. In both of these deals, the customer chose Fortinet based on performance, flexibility and the ability to deploy a hybrid model architecture.

We saw a substantial increase in large deals in the quarter across all categories, driven by improved sales execution in enterprises as well as an increase in Fortinet Security Fabric deals. These are generally larger, multiproduct deals and now include higher price, enterprise subscriptions and services bundles. Deals over $100,000 grew 27%; deals over $250,000 grew 24%; and deals over $500,000 grew 31%. We had a record 39 deals over $1 million, which represents 39% growth over the same period in 2015. Our breakdown of billings across our top five verticals was service provider at 22%, government at 18%, financial services at 12%, retail at 8% and education at 7%.

Now, let me turn to the geographic breakdown of billings for Q4. Americas billings grew 19%; EMEA billings grew 24%; and APAC billings grew 22%. Enterprise sales in North America rebounded meaningfully from prior quarters, and sales executions improved. EMEA also benefited from improved sales execution and strengthen in enterprise and Security Fabric sales led by strong performance in Germany, Spain and the Netherlands. APAC benefited from strong performance in Japan and Southeast Asia.

Now, turning to billings by product segment on slide four. High end products accounted for 41% of total product billings; our mid-range products accounting for 29% and entry-level products, accounted for 30%.

Total revenue was $363 million in the quarter, up 22% year-over-year. As you could see on slide five, revenue performance was driven by the combination of 10% year-over-year product revenue growth and 34% year-over-year services revenue growth. This shift to higher service growth, reflects our ongoing success in driving higher price subscription bundle, metered model business and virtual solutions.

On a geographic basis, you can see on slides six and seven that revenue continues to be diversified globally, which remains a key strength of our business. In the Americas, revenue grew 23% to $150 million, EMEA revenue grew 22% to $140 million, and APAC revenue grew 22% to $72 million.

Moving to non-GAAP expenses and profitability. During the fourth quarter, our non-GAAP gross margin was 76%, above our guidance of 74%. Non-GAAP services gross margin was 84%. Non-GAAP product gross margin improved to 65%. Non-GAAP gross margin was again positively impacted by higher sales of software such as our security solutions for cloud and virtual deployment. The growth in higher priced services such as enterprise bundles, product mix and the benefit of lower overhead and warrant costs. Non-GAAP operating expenses were $195 million during the fourth quarter, resulting in a non-GAAP operating income of $81 million or 22% of total revenue. The upside was driven by our ongoing focus and discipline in driving operational efficiencies. Expenses in all categories were down sequentially as a percent of revenue. Non-GAAP net income for the fourth quarter was $53 million or $0.30 per share, which was $0.09 above our guidance range based on approximately 177 million diluted shares outstanding. The annualized non-GAAP tax rate for 2016 remained 33%.

As seen on slides eight and nine, we ended Q4 with the strong balance sheet, including $1.311 billion in cash and investments. Free cash flow in the quarter was $84 million. Annualized inventory turns for Q4 were 1.8; deferred revenue increased to $1.35 billion, up $244 million or 31% year-over-year. DSO was 78 days, one day lower than the fourth quarter of 2015. Finally, during the fourth quarter, Fortinet repurchased $36 million of our common stock at an average price of $30.92. For the full year of 2016, we repurchased a total of $111 million of our common stock at an average price of $28.76. $189 million remain available for share repurchases through December 31, 2017 under our currently authorized $300 million share repurchase program.

Now, let me briefly discuss full year 2016 results, a summary of which you can find on slide 10. Total revenue in 2016 was $1.275 billion, representing growth of 26% over fiscal 2015. Annual gross margin was 75% compared to 73% in 2015. Annual operating margin was 15% compared to 13% in 2015 and consistent with our guidance at the beginning of 2016. On a diluted basis, non-GAAP earnings per share were $0.73 in 2016 compared to $0.51 in 2015. Cash flow from operations was $346 million. Free cash flow was $279 million.

Before I discuss guidance for the first quarter and 2017, I want to provide some detail around our future real estate intentions. As I have mentioned in past discussions, Fortinet anticipates expansion requirements over the next several years both at headquarters in California as well as in Vancouver. In both of these locations, we are opportunistically expanding our footprint in a controlled and staged approach. We expect that these moves will be accretive over the long term.

Including the cost of real estate and other items, we anticipate CapEx of approximately 140 million to $150 million in 2017. Roughly $15 million to $20 million of this number was pushed forward from last year, when we estimated $80 million to $90 million in CapEx, but only used $67 million. Cash flow from operations combined with ongoing improvements and balance sheet efficiency should continue to produce strong free cash flow.

Now, let me finish with our guidance for the first quarter and full year of 2017. As seen on slide 11, as a remainder, all forward-looking statements including all of the guidance statements provided are subject to Kelly’s caution at the start of this call.

Fortinet’s market opportunity and competitive advantage is significant. Our investments have helped lay the foundation for our future growth, share gains and increasing profitability. With our model layer, end-to-end Security Fabric, Fortinet is well-positioned to benefit from industry trends such as security vendor consolidation, internal segmentation, IoT and the move to the cloud. Although these industry trends will ultimately benefit Fortinet, we believe they could continue to elongate sales cycle. Additionally, although we saw substantial improvements in the fourth quarter, we believe that sales productivity will continue to ramp over time as our sales force matures. These factors along with the typical seasonality of the business and our expense structure are carefully factored into our near-term outlook.

During Q1, we expect billings to be in the range of $380 million to $388 million, up approximately 16% year-over-year at the mid-point. Total revenue is expected to be in the range of $330 million to $335 million, up 17% year-over-year at the mid-point. Non-GAAP gross margin is expected to be approximately 74% to 75%. Non-GAAP operating margin is expected to be in the range of 11% to 12%; this reflect the impact of lower revenue and higher cost associated with the typical first quarter as well as increased G&A expenses associated with transitioning to new accounting standards. And finally, we expect non-GAAP earnings per share to be in the range of $0.15 to $0.16 based on an expected diluted share count in the range of 178 million to 180 million fully diluted shares.

For 2017, we expect full year billings in the range of $1.750 billion to $1.770 billion, up 16% year-over-year at the midpoint. We expect total revenue to be in the range of $1.470 billion to $1.480 billion, up 16% year-over-year at the midpoint. Non-GAAP gross margin is expected to be approximately 74% to 75%. We expect our non-GAAP operating margin to improve to 16%. Finally, we expect non-GAAP earnings per share for 2017 to be in the range of approximately $0.87 to $0.89, based on an expected diluted share count in the range of 181 million to 183 million fully diluted shares.

In closing, I would like to thank Fortinet employees, partners, customers and shareholders for their continued confidence and support. With that Ken, Kelly, and I’ll now take your questions.

Operator, you may start the Q&A.

Question-and-Answer Session

Operator

Thank you. [Operator Instructions] Our first question comes from Gabriela Borges with Goldman Sachs. Your line is now open.

Gabriela Borges

Maybe just a high level question, if I could, on the health of the environment and the overall visibility that you have into the business. In the past, there’s been a little bit of discussion around sales cycles elongating and digestion of product. Maybe you could just give us an update there and in general on the broader willingness of customers to spend on network security today. Thank you.

Drew Del Matto

Sure, Gabriela. I would start with I think the general environment. Customers are very willing to spend on security and certainly network security. The trends of consolidation, cloud, mobile, IoT, the next-gen architectures continue to be in the forefront of their mind. What we have seen in the past is that we’ve just seen the elongated sales cycles. We seem to close -- we did a good job of closing what we had on the table in Q4. I would say, overall, there is still some digesting out there, certainly still some of this digesting phase, customers are still evaluating, and hopefully over the next couple of years, they move certainly into the more of the purchase stage.

Ken Xie

This is Ken. I think we see some new trend like last year and also 2015, you see some rush buying for [indiscernible]. Now, it’s a kind of a new trend really to secure the infrastructure. So, that the fabric method [ph] working quite well, whether internal segmentation, or how to secure whole infrastructure is just a few point in the network side. That’s actually helping drive a lot of bigger deals and new growth opportunities.

Operator

And our next question comes from the line of Sterling Auty with JP Morgan. Your line is now open.

Sterling Auty

I wondered if you could go a little bit deeper on the cloud. You mentioned the cloud business double. But, can you give us a sense, how much of that business is under the meter business model; how much of that is actual virtual firewall versus physical appliances that might be going into private cloud or other types of cloud implementations where it’s still a physical appliance versus virtual?

Drew Del Matto

The metered model piece, Sterling, is the smallest component; I would say, the virtual machine piece is the next; and then, obviously, the hardware is still predominant. We gave an example -- I think we gave a couple of examples of hybrid models where they are building out infrastructure, and one of the appeal -- part of the appeal of the fabric is clearly that not only can they expand, whether it’s hardware or metered model, do it globally with AWS and us or whatever -- whoever, whichever cloud provider they provide, given that flexibility and that advantage. And what they really like I believe is the breadth of our product portfolio, what the fabric provides there. And we heard a lot in security orchestration, the fact that we could basically keep all the things updated at end-to-end and do it virtual, physical and basically allow them to expand as they want.

Operator

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

Melissa Gorham

So, Drew, you talked about better sales productivity this quarter. And over the past, I guess year or so, you’ve talked about making tweaks to the sales force and I think you talked about it last quarter as well. So, can we assume that those changes are now over and productivity is just going to be coming from the sales force getting more mature or are you still making any material changes to the sales force?

Drew Del Matto

I’ll start with the last part of your question. We don’t see any material changes certainly at this point, Melissa. But we do believe there’s room to drive higher productivity, and we’re continually focused through that through our marketing efforts; we’re fighting our lead generation, our training, and just building that end-to-end go-to-market model. We really do believe we’re doing better that feels like the engine is more in place, but there’s probably still quite honestly some work to do there.

Operator

And our next question comes from the line of Walter Pritchard with Citigroup. Your line is now open.

Unidentified Analyst

Hey, guys, it’s Jim on for Walter. Congrats on the quarter and thanks for the question. Drew, it looks like you hired about just under 50 heads in the quarter, which is the lowest amount since 2010. Are you guys thinking that you’re at full scale now or how should we think about hiring activity as we progress through fiscal 2017 and 2018?

Drew Del Matto

Well, we’ve given you the guidance on margins, Jim. I think it’s obviously headcounts reflected in that. We were very focused on driving productivity. We were very focused on -- the model here is a lean, flat organization with low friction. And what we did was reduced admin and overlay layers, really with the ultimate goal of driving high velocity and getting better visibility from top to bottom of the Company. And so, we’ll continue to do that. We’re going to continue to hire though; we absolutely are -- we believe we have opportunity to grow, as reflected obviously in our guidance. And so, we’ll continue to hire. So, I wouldn’t look at past -- last quarter’s hiring rate as an indication fairly of the future. I would just look more to the guidance that we gave.

Operator

And our next question comes from the line of Saket Kalia with Barclays Capital. Your line is now open.

Saket Kalia

Drew, can you just remind us about how big the non-FortiGate part of the business is? Security Fabric has been out for a little while now. So, could you just maybe frame roughly what percentage of the business has been non-FortiGate pieces, and how fast that’s growing?

Drew Del Matto

It’s hard to share numbers, but I would say it’s getting more meaningful. I would say that it was slightly less than double from last quarter. So, it’s growing very nicely. One thing I would point out with the enterprise bundles, which I called out I think a few times in the script, were very good story, where we’re seeing a nice uptake on that. And that really came out in Q2. We saw nice quarter in Q3 on those nice uptake and we saw even better in Q4, and basically that’s just a higher price bundle with ATP and mobile added. So, those drivers altogether really form the fabric and beyond story, and that’s what we’re seeing customers really -- we’re really helping them support the next-gen architectures.

Operator

And our next question comes from Shaul Eyal with Oppenheimer. Your line is now open.

Shaul Eyal

Drew or Ken, last quarter, you mentioned some macro issues impacting, I believe it was your UK, Latin American operations; clearly this quarter’s results stand in sharp contrast. Just trying to understand if some of those third quarter headwinds are gradually subsiding or was that strictly improved execution and discipline this quarter?

Drew Del Matto

Well, I would start with -- I think it was clearly better productivity or execution overall for sure. The fabric is a good story, Shaul; it’s resonating. And some of the items I just shared with Saket, I think kind of help illustrate that customers are really taking to the fabric story. So that’s really I think the first point. The only macro issue that I would really sight this quarter would be Brazil, which -- if you go a year back, it would have been a very good story and beyond that -- prior to that strong -- very strong country for us. And that continues to be a very challenging country.

Operator

And our next question comes from the line of Gregg Moskowitz with Cowen & Co. Your line is now open.

Gregg Moskowitz

Is there any additional color that you can provide on the sales productivity improvements this quarter? In other words, is there something perhaps that you can point to in lead gen, sales on-boarding et cetera that gives you confidence that the performance you saw in Q4 is more than just strong Q4 seasonality and a likely budget for us?

Drew Del Matto

Yes, I think probably just some seasoning of the team. You bring in -- we got in a lot of people. I think sometimes it just takes time for the gears to connect completely, especially when you are building a lot of functions at the same time. And so, I think that’s the piece of it, the season, and you get more focused, things get easier. I would add and repeat what I said earlier, I do believe that having a flatter, leaner administrative and overlay function really does create greater visibility and focus on what we need to do to accomplish and achieve. And I think that’s what we did.

Ken Xie

And also, we are enhancing [ph] the lead gen, the marketing side; that also will help in improve the [indiscernible]. And I think the process to increase the productivity is still ongoing. And we still try to keeping improving the structure and also supporting by the other part like marketing, some other customer supporting and also the new launch of the product to keeping driving the growth.

Operator

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

Michael Turits

Hi guys, couple of questions. Obviously, it was a great rebound in products growth, especially, I mean services were strong too but fantastic to see that reacceleration of product. Looking at your guidance in the 1Q and assuming kind of seasonality and reasonable conservativeness, it still looks like you’ve been making some services that the product guide on a year-over-year basis looks pretty weak. So, is that just down 1% it looks like, and it’s just an estimate. But there is something that -- have visibility that strength you saw in product this quarter could continue into next quarter?

Drew Del Matto

It’s very hard to predict, Michael. Clearly, there is a shift going on with us and others, it feels industry-wide where you see the shift and obviously on the virtual side, some cloud. And then, we just see more of a waiting towards services. And this is -- a lot of this is by design by the way. We are really trying to wait the money -- we are really trying to drive to higher customer lifetime value. And the way you do that is attribute more to the recurring higher profitability side of the business. And as we look at the enterprise bundle for instance, that’s clearly a vehicle to do that, and it’s working. And so, it’s kind of hard to predict.

And also the only other point I would lay out there, some of the earlier questions around just the general environment. You still have to be, let’s say, cautiously optimistic as customers are really still evaluating to the large extent their next gen architecture, there is still some digestion. And obviously, we have to push as hard as we can, but I think we have to have the appropriate level of caution.

Michael Turits

And then, the follow-up is on CapEx, which is significantly higher. I know you say that was 15 to 20; I think you said it was pushed off from this year to next. But it’s still mid $100 million to $200 million and it’s really high. So, obviously, you don’t give 2018 guidance, but should we -- how long before this accelerated CapEx spends are over? So, we think about 2018 as being back to a normal year or percent of revenues in backend or something [Multiple Speaker]?

Drew Del Matto

Sure, Michael. Yes. Sorry, and I have to take debate on correcting you; it wasn’t $200 million...

Michael Turits

No, it’s 1 to 200, not 200 sorry, 1 to 200.

Drew Del Matto

No, I didn’t say that. I said -- I think I said 130 to 150 or 140 to 150. We can go back and check that, but the -- I believe 150 was the top end. And that’s real estate and our normal run rate, if you will, about the CapEx. We will continue it for couple of years. Now, at that level, it’s hard to predict -- as you could see, just even in last quarter when we held to the CapEx guidance that we were off significantly, part of it has to do with buying mobile products, purchases and how people buy and how people sell those properties. And it just takes a while and then it takes a while to get permits and all of this.

So, we’re kind of thinking over the next several years, we’ll see some of this. I’m really guiding out, but I would say that continue to be some real estate, over time as we clear one property and then we do look to build a campus there around the HQ area. And just by the way, I mean if we can find a better opportunity, we’re clearly going to look at that, we’re married to any given location; we’re trying to do the best thing. And I would remind you, everything we’re doing, we believe is accretive. One thing I would point out on real estate, we bought a warehouse about a year ago, and we were running out of space, so we bought a warehouse. And part of the reason the product gross margin is up is because the warehouse is now driving margin benefit or scale benefit that we wouldn’t have otherwise seen. So, if you do buy these properties, you can be in them anyway, it does make sense to buy them.

Operator

And our next question comes from the line of Jonathan Ho with William Blair. Your line is now open.

Jonathan Ho

I just wanted to start off with the North American enterprise. And can you talk about maybe the recovery there? And is there sort of further opportunity to see improvement and what are some amount of the big changes that may be had an impact?

Ken Xie

Yes. This is Ken. Definitely, there is a lot of room for improving in the North American enterprise. And not only just enterprise but also see some opportunity from the carrier service provider, the cloud side and also the channel SMB side. But, it’s starting more focus on enterprise, we made some improvement but there is still a lot of room to grow compared to some other competitors. And that’s where the enhancement of the marketing like lead gen, some other channel program and also starting helping them, starting to see some good results. So, we like I said, just coming from the Partner Conference in about a couple of weeks ago, we see the partner -- some customers also -- they see a pretty -- enthusiasm we see from the conference is much stronger than we see before, and they all like the new program and also the new product we’re offering. And that’s really, if you can, really helping the growth going forward.

Drew Del Matto

I think the vision, Jonathan, when I talk to customers and when Ken and I talk to customers, the vision resonates the breadth of portfolio, the Fabric Story. And you really see -- I do think the non-FortiGate sales are an illustration of the uptake in the fabric and resonance of that with our customers. And again, they want to buy more security; they want to buy sensibly; they want it to work across their network and through IoT into the cloud. And we’re giving them that vision, and I think the vision part of it is not to be underestimated.

Operator

And our next question comes from the line of Catharine Trebnick with Dougherty. Your line is now open.

Catharine Trebnick

Thanks for taking my question; my has to do with the service provider segment, Ken. What type of opportunities are you seeing for the virtual firewall?

Ken Xie

I think like a couple of months, we started integrate the cloud and that carrier service provider came together, and that’s actually -- it’s a long-term vision we have, eventually like some of the cloud provider also become some service provider. And also I mentioned in script, we see the cloud business grow faster than other part of our business. And we have the best carrier service provider position among all the other competitors because of our strong cloud offering and also the virtualized and also the hardware performance is a huge advantage. But we also see the -- the service provider also starting transition themselves little bit from the traditional carrier offer some [indiscernible] they also started offering additional service and also some content there. So, that’s why we feel we’re well-positioned to drive the future business there, whether into the cloud or the mobile, we have market opportunities both on the product offerings and new service offerings.

Drew Del Matto

Other than that, what we’re hearing out of that sector is just that -- as they go more virtual, they do talk about that. It actually creates more complexity and it requires -- it necessitates more performance and really the breadth of security. And again, similar to my last answer, it is the fabric resonating. It’s the ability to provide the high performance, obviously procedures [ph] provide and I think we had a -- we’ve got some announcements recently on our high performance products but those are drivers along with complexities and the breadth of security, the breadth of security we provide is critical.

Ken Xie

Also, I mentioned we deliver the security to the cloud and for the cloud. So, that’s both with the service provider offer to the customer and also for the cloud provider themselves, as a lot of opportunity we see.

Operator

And our next question comes from the line of Hendi Susanto with Gabelli & Company. Your line is now open.

Hendi Susanto

Drew, how should we think of the tax framework if the U.S. government lowers the federal tax rate under the new administration?

Drew Del Matto

It’s very early and we are not -- obviously not quite sure what will happen there. We would hope that it would be obviously a tailwind, but there is so much variability in there right now, it’s just hard to predict. For right now, we will just stay where we’re modeled. And then, when we get beyond kind of all the, if you will, dialog and back forth phase, I think we’ll have a better opportunity to give you firmer guidance.

Hendi Susanto

And then, if I may ask one question for Ken. Ken, now that we’ve finished the year 2016, would you be able to shed some color on how much penetration your subscription business is today versus a year ago and how much upside opportunities remaining?

Ken Xie

Subscription, you mean the…

Drew Del Matto

The mix is higher.

Ken Xie

You mean enterprise service model or…

Drew Del Matto

Hendi, I think you are talking about the mix, I mean which would…

Hendi Susanto

Product…

Drew Del Matto

Clearly be higher, the product is primarily hardware. So most of the subscription fall to deferred because they are delivered over time or they would fall in service line -- service revenue line as they’re amortized. So, you would really have the numbers. The only other thing I would go back to the fact that we just have more types of virtual products and term licenses and so forth, and the enterprise security which is obviously part of what’s driving higher deferred.

Ken Xie

Also we started offer like we call the enterprise bundle about two, three quarters ago, we see very strong growth, almost quarter-over-quarter, and that’s really helping the service part and also helping the margin. So, that’s where offered additional ATP and also mobile cloud security in enterprise bundle. We see a lot of customer need this additional service is one of the strong driver of the gross margin and growth.

Operator

And our next question comes from the line of John Lucia with JMP Securities. Your line is now open.

John Lucia

Most of the major firewall vendors talk about providing firewall capabilities on-premise and in the cloud being able to connect the two; they also talk about consolidation around the firewall in terms of subscription services. Can you just give us little more detail on what makes the Fortinet Fabric differentiated versus the others, particularly as it relates to the cloud and the integration there?

Ken Xie

Yes. We definitely see the strong demand for both on-premise as well as on cloud and also the balance of two deployment but also we have additional in the fabric like from the endpoint working with other. Also we mostly partner with some other endpoint provider people together and same time, we have access path that’s FortiWiFi other competitor has. And then we have the application that we mentioned FortiMail, FortiWeb and some DDoS deployment is also helping, and that’s we also offer pretty strong solution there and then pass the cloud IoT. So, we have a -- I think we are number one on the unit deployed globally, probably more than double the number two. That’s also helping driving these broad favorable solutions. And we also see some other networking gears starting connect together. So, we also offer, both the secured monitor application with some other networking device and especially try to do the security and analysis part. So that also drives a lot of, what we call, the fabric growth.

John Lucia

And then one more question. Your revenue was much better than expected and OpEx came in a little lower than our estimate. I would have expected variable expenses to be higher due to the revenue outperformance. I just wanted to see, if there were any expenses that push into Q1. And I know you had maybe a lower headcount than you wanted in Q4. Then also just if there has been any change in terms of thinking around investing; is there any reason why you wouldn’t pull forward that goal of 20% operating margin exiting 2020, given the outperformance here?

Drew Del Matto

So, I think there are couple of questions in there. First of all, we clearly can’t -- we didn’t -- I think you asked me if I pushed out any expenses; is that the first question?

John Lucia

Yes from Q4 into Q1?

Drew Del Matto

I said it already. I think you’re asking about why wouldn’t -- because commissions would be the major variable expense I think. It will grow obviously the margin line, as you saw another product, you have to expense the hardware. That would be one thing, but the commissions would be the other. And commissions is on as a percent of billing. And so, as we drive operational efficiencies and I think we remove the overlays, we end up with a more efficient structure. And that’s really the answer of how we did it in Q4. We started those things in Q3; they certainly bore fruit in Q4. And also just other expense, just expense discipline, I would say, grown the Company, just more focus on expense discipline, which will continue.

As far as go forward, you have our guidance. We’re committed to the 20%, existing 20; we remain committed and we’ll see how it goes from there.

Operator

[Operator Instructions] And our next question comes from the line of Taz Koujalgi with Deutsche Bank. Your line is now open.

Taz Koujalgi

I do have a question on the subscription business, different bundles. It seems like you have three bundles now. You have the old traditional bundles you had, the enterprise bundle, I think in Q4 you launched the 360 bundle. Can you talk about how much -- what was the mix in the quarter among those three bundles?

Drew Del Matto

I don’t have a mix to share. I think Ken shared that the enterprise bundle just about doubled quarter-over-quarter, slightly less than that to be fair. But, it was a nice -- and I think we even mentioned in Q3 that it was a nice ramp. So, that we’ve seen a nice uptick there. But the three bundles are the core UTM bundle, which is our traditional bundle. A reminder, we raised prices on that just about two years ago. And then the enterprise bundle which was really Q2 of this year. We’ve been out there sort of but we hadn’t really been marketing it through all the price books, just kind of testing it. And then that had a nice ramp throughout the year since Q2. And then the 360 bundle, and I think that was a little early because, in that is the SIEM, and we’re just early, FortiSIEM is in that, it’s just still little early, we just integrated that in Q3 really.

Ken Xie

We’re still moving that; 368 bundle is still in the trial, beta stage that really launched.

Drew Del Matto

Yes, too early. It’s in there but it’s too early.

Taz Koujalgi

What is the difference in price points in those three bundles?

Drew Del Matto

I don’t have.

Ken Xie

It’s on the copy for sure there, but also think the 360, we still try to improve in a handset; I don’t think we formally launched in some of country region yet.

Drew Del Matto

Here, I have it. We do have the bundle. We of course have the template handy. So, on the UTM bundle, 24 with -- and I’m just doing it -- you can give me an 855 24x7 or 360. The 24x7 support was for UTM with 65% of the hardware price, Taz. And the enterprise bundle is 90% of the hardware price and 24x7. And that’s in our template, if you have one of those.

Taz Koujalgi

And did you mention you’ve given the -- did you give the price for the 360 bundle?

Drew Del Matto

I’m sorry, 360, just a second. You go -- so for UTM…

Taz Koujalgi

That’s added 10?

Drew Del Matto

Yes, you would add 10 percentage points. So, for UTM -- you can get 360 either with UTM or enterprise, and basically that includes FortiSIEM and some monitoring of your system to see kind of where you need to have the devices so to speak around the -- in your environment. And so that’s at the UTM level, 75% of the hardware price versus 65% for the 24x7. And then in the enterprise bundle, the 24x7, as I said was 90% of the hardware price but if you buy this 360 option, it’s at 100% of the hardware price but again that one is a little early.

Ken Xie

Basically 360 just has a health check for other deployment that will help monitor how the deployment going on like weekly or monthly. So, let’s add 10% on top of that.

Operator

And our next question comes from the line of Tal Liani with Bank of America. Your line is now open.

Mike Feldman

Hi guys, this is Mike Feldman on for Tal, thanks for taking my question. Service provider was good sequentially but year-over-year the growth still continues to decelerate, I believe it was up only about 6%. What’s causing the slowdown in that environment and what are your expectations for 2017? And then separately, have you seen any change to the run rate in that environment given the increasing competition in Palo Alto and Check Point, both of those companies have some new higher end firewalls addressing that market?

Drew Del Matto

2016, I think we did very well globally quite frankly, I think some select providers probably more in the U.S. 2016 was more of a valuation year we think. 2017, more likely a decision year probably in the back half of the year somewhere is what we’re hearing. We hear that they’re more focused on virtual solutions and CapEx and what we’re hearing is that we’re the best provider with our fabric again, with breadth of portfolio, security orchestration, end-to-end through IoT to the cloud, whether they’re using it internally or externally and I think they’re trying to basically doing the same for both. And then obviously in service provider, we provide performance that none of the competitors actually can provide. And we don’t -- we haven’t lost any deal to them that we’re aware of. So, I don’t think any of that’s changed.

Ken Xie

Also we’re launching the new product like the 7000 series, 7040 about quarter ago, now we just launched the 7060. So that’s the farthest next generation product in the whole industry and also the highest product in our own product line. Plus this 3980, that’s a single appliance, I don’t see any competitor have single appliance can deliver service throughput. That’s also kind of a sometime customer want a evaluate its product and same time like Drew said, a lot of service providers, carrier cloud providers, they are also changing their business model from offering security line, now they also add additional service and also compensate. So with all this evaluation, sometime the decision can be longer. And also the new product received very strong interest from all the customers, service providers. So, we do see quite a lot of potential going forward.

Operator

And our last question comes from the line of Ken Talanian with Evercore ISI. Your line is now open.

Fenn Hoffman

Hi guys. This is actually Fenn Hoffman on for Ken. Thanks for squeezing me in here. I just wanted to dig a little deeper, if I could on the enterprise subscription bundles. If you have a sense for whether the growth there is being driven primarily by new sales or sales to existing clients? Thanks.

Drew Del Matto

It’s probably both. It’s just hard to break that out right now, too early to tell. But it’s probably both. I mean, we are obviously offering it both and then you would generally see it on a new product deployment.

Fenn Hoffman

And just a quick follow-up if I could. You guys saw quite a jump in deals over 500,000. I am just wondering what some of the primary drivers behind those have been?

Drew Del Matto

Just enterprise focus; I think it’s just a signal that better execution in the enterprise globally.

Ken Xie

Also the fabric story also makes the deal larger, because there is multiple products starting together, not just the FortiGate, but also like I mentioned from the mail and also some even some WiFi.

Operator

And I am showing no further questions at this time. I would now like to turn the call back over to Kelly Blough for closing remarks.

Kelly Blough

We want to thank everyone again for participating in the call today. If you want -- if you have further questions, please dial in for the Q&A session that begins at 3:30 Pacific Time. Thank you very much.

Operator

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

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