Fortinet, Inc. (FTNT) Earnings Call Transcript & Summary

So nice to see you. Thank you for doing this. -- it's been an interesting as it always is, a couple of weeks for both tech stocks and Fortinet. Yes. I mean it has been crazy overall, right? .

Crazy. Crazy take.

And I will tell you that a lot of we're live. Sorry. Okay. We're going to go ahead and get started. So not trying to shut down that group, but -- all right. I imagine I'm going to stall for a little bit while -- because I think there's folks out in the hall getting ready to join us I will say it's -- we're thrilled to have Fortinet here. It's a company I've covered for a long time and a great company in the market, probably best firewalls out there. I will all say at this particular time, you'll be happy to know that you won the prize and you're wondering what was the price. Surprise is the most frequent source of questions right now that we get on any company is Fortinet. And it relates to the firewall market, I think folks rotate to Fortinet because it's more of a proxy of a firewall market follow, you got all these numbers going in and out inorganic organic. Checkpoint is losing share. So people don't really rotate on that particular company. So you guys are the most frequent incoming question we've had in the last couple of weeks. So for that, we're grateful that you're here.

With that said, let's jump into a few things, and we'll start at the market level first. And so my first question relates to just that the firewall market. And as you think about the puts and takes of calendar year as we're coming off of '26 year effectively and comparing and contrasting that to COVID, which was also an interesting time, call it, '21, '22, how would you characterize the difference? And again, I'm asking at a market level to kind of normalize. But how would you different compare and contrast the current period versus the COVID period?

Yes. I think the main difference between now and the coveted is during COVID, companies were preparing for remote access. And that was the main use case for upgrading their infrastructure. buying firewalls and then also adding on Sasifunctionality. Now in 26/27, I think we have a lot more drivers for growth. We have AI that needs to be secured. We have solvency around AI. And for us, solvency is an important topic or hybrid infrastructure, control of your infrastructure. because we service a lot of companies outside the U.S. And the customers are looking for more control over their infrastructure. Then we have for us, for Fortinet, a big market is OT security and that continues to get traction. And I think we all hear a lot about OT risks, whether it's the refrigerators being out of control or water systems being attacked just as some examples last year and '25 airport terminals were hacked. So there's a lot around OT security that continues to be in the news and elevate that market for us. And why is Fortinet well positioned because OT security is more of a hardware than a software play, while we have products in all categories, I think we differentiate our , as you said, nicely so, our firewalls are best-in-class. So that's where we have a lot of drivers that create demand for firewalls. A couple of years ago, I think everybody was talking about the cloud and said, well, Fortinet, your market is shrinking. We don't really see that the market is shrinking. We see that there's more use cases for all the functionality we're building into the firewall.

Okay. Okay. Let's take a step back is where I've asked every company that I've visited with today, the similar question -- in terms of budgets for next year, your sales reps are coming back to you probably trying to work down their quotas already -- at the same time to say it's right. That's right. At the same time, getting feedback presumably from corporates on budgets for your TAM? And what a lot of folks wonder about in security is, okay, how much your budget is going up or down for security. But really, it's even a fine -- a little double-click on that is there's many more demands and requests on security budgets than there's dollars. And so where is the pool of funds going to come from that meets all the requirements being asked of departments. Like how -- what are you hearing about security budgets for next year. And I'll give you more -- I've had conversations with our internal folks from BMO -- we have a security budget. It's going to grow x next year, but we're also tapping into a whole another pool of funds that's been created to support AI. I don't know if that's common. But give us a little bit of discussion on security budgets next year.

So I think there is SP-5 There are 2 benefits for Fortinet, right? One is, yes, security budgets are increasing. And typically, when you invest in AI, you need to build out security for eye and that comes with its own budget as AI is budgeted for. But then also, as you said, companies don't have infinite budgets. So where Fortinet plays a role is we can consolidate multiple functions in 1 firewall. Best example, and we see a lot of traction even though it may be considered our tech as SD-WAN. Many companies still have 2 providers and pay basically twice the price when they could buy a firewall from Fortinet and consolidate 2 vendors into 1. And so may move for more other security needs -- and so that vendor consolidation, reducing from 200 apps to a couple of vendors is something that we see and that helps customers do more with -- not less, but with the same.

Okay. And have you got any numbers about what security budgets may increase next year?

I hear like 5% to 10%, but we shall see. I think that the threat environment remains active yes. I don't think it's getting any better. So from that perspective, we may also see what we saw in 2026. Shifting from other budgets to security just because customers realize that security is an important aspect that they cannot delay.

Okay. Okay. Let's go into a little bit of -- you recently reported your quarter. I think there was a little bit of confusion, say, on the second half growth guidance versus what happened in the first half. So maybe just review at a top level, sort of how the various factors that would influence the guidance to include price and availability. How did that shape or inform your guidance for second half versus first half?

So let me start with the beginning of the year. At the beginning of the year, we assumed a pretty normal year, right, something like 10% to 15% growth without including price benefits. And Fortinet is fortunate in a way that we have typically 2 quarters worth of on-hand inventory. So then the prices started creeping up it was something we knew -- and we were able to supply our customers pretty quickly and also pick up demand from our competitors who were already constrained with supply shortages. So we had an outsized first half, which was partially demand of our own customers and partially demand that we were fulfilling from competitors and driving market share gains. In the second half of the year, we are -- not that we are supply chain constraint, but we don't have the same advantage because now the lead times have increased. Our prices have increased, and we can't aggressively discount or we still aggressively discount, but not as much as we had the lower COGS on the books. So I think half year 2 is more normalized and half year 1 was just outsized because we were in a fortunate position to take market share gains.

And so just if I drill down on -- Ken was pretty clear, you had some excess carrier. I'm not sure if excess is the right term, but availability in the first half. So you look at second half, you have normal availability of inventory, so you're not -- if you got incremental demand, you could satisfy that incremental demand I'm just -- I'm not sure that...

We have no inventory on hand, but if there's accelerated demand, we have less capability to pull in production just because the lead times have increased. While we've given out longer commitments to our contract manufacturers, there's not as much of an ability for them to get all the components.

A little flex then. Okay. Okay. And then -- so inventory may be less availability, which also, by the way, benefiting in terms of price because you have lower cost on your books. Absolutely. So now you have more of a consistent level of inventory, probably less flexibility on the cost. But on pricing, your price increases in the second half are actually higher than your first half? And so that will be an extra benefit. But do you think price realization will be consistent with the price increases?

So far, we see similar price realization. Yes. And -- and so I think from our perspective, the benefit is that it's a supply chain constrained market. So our competitiveness hasn't decreased. Everybody has the same issue. Their prices go up. They have raised prices. And so our competitive pricing hasn't -- is still as good as it was before. It's -- for customers, it's a little bit more unfortunate because they need to pay more. And the other part is that because we have our own ASIC and especially in the firewalls, we have one component that is less impacted by the price increases. So it allows us to be more competitive as well.

Okay. And then maybe reflect on the customer behaviors associated with those price increases, right? So you had incredible demand in Q1, Q2?

Yes. .

And talk a little bit about what you think customer behavior was as it relates to those price increases and including comments on how that may have impacted Q3, Q4. like maybe customers were buying a little bit ahead of gas pricing?

Right. I mean I think what sales did at the beginning of the year when they saw that the prices are going up, they said to the customers hey, if you have plans to upgrade and we know we had customers that needed to upgrade throughout the year. We suggest you do it earlier because the prices go up, and we can't guarantee availability. So there's definitely some of this element. On the other hand, in Q2, we were taking share from competitors because of all hand inventory. But I wouldn't underestimate also the additional units or customer demand because of metals. I think the AI revelations in April that you can -- that the time to identify problems in your software and exploit them have shortened to milliseconds after release comes out, has been a big 1 and it's going to continuously drive demand. And why is this beneficial for the firewall? Because in the end, no customer, even if a patch comes out, can deploy it right away. Customers need to go through testing, the integration testing, they need maintenance windows. So they need protection why they are planning to apply the upgrade. And firewalls and also SaaS for cloud deployed software is an important security measure to buy time. So that's what drives continued demand.

So is the replay cycle or refresh cycle staying the same? Because it usually firewalls are 5 to 6 years. And because of Methos and security vulnerabilities, does that contract you think the replacement cycle?

What we see is with all the innovation that goes into OOS, customers will have to upgrade a little bit earlier because all the new functionality requires higher-end devices. So while devices may not be out of support, you may not be able to turn on all the features and functionality that you want with a lower-power device, lower memory device. So that's also when you look at my remarks over the last couple of quarters, what we've seen is that the average ASP net of price increase has gone up, which shows us that customers are buying within each firewall band, hire devices that allow them to switch on more functionality, which is good for us because it gives us the ability to upsell the customers on services over time.

We're going to stick with firewalls before we turn to services in a second. But what I think investors are really sort of stuck on, and I reflect back on the post-COVID period when Peter used to yell at me.

I won't.

Is investors are really trying to understand what does this really dynamic period of firewall being implied for next year? And so you have a 50% comp in 1 instance. So extraordinary demand, again, some share gains, what it may portend for next year -- and so a couple of different questions related to it again, just you can speak to either market dynamics or Fortinet. But #1, you have an exit rate established for Q4 implied for your guide. I don't know if that's the right jump-off point. as we're thinking about product growth next year? Or as you've talked about -- you think the durable growth maybe is mid-teens, 15% or something along those lines. But just any guidepost that we should be thinking about -- as it relates to all the moving pieces, price increases, inventory really hard compares, anything else you want us to consider as we're getting read to turn the corner on the new year.

But -- so I'm not going to guide today.

Not asking to.

But -- so from my perspective or from our perspective, the market dynamics are absolutely intact. And they are much broader than they were during COVID. So from that perspective, we are very confident about growth over the next couple of years, and we've always said our goal post is that we outgrow the market. And because we don't do big acquisitions, our growth rates are pretty much organic, right? And yes, we benefited from pricing increases this year. But as did our competitors. So it's a like-for-like. Yes. From a growth rate perspective, there's still a lot of new demand drivers for product. And as I said, there is still also a significant cohort of customers that have older devices that they purchased during COVID that we can upgrade. So I'm not worried about continuing to sell product into our customer base and acquire new customers. We also have competitors that have big refresh cycles coming up. So that's an opportunity to take some market share. And if the market is good, we should be benefiting from it.

So I'll break it down in a couple of pieces. But any way to think about how prices may impact the market next year. So everybody has been taking prices this year because component costs have been going up. Is it as simple as thing about, okay, price increases will be at whatever component costs do? Or is there a different way to think about what price increases may be for firewalls broadly next year?

So I think we've been pretty clear to the investors that we will adjust pricing to make sure that our gross margin stays around 80% between service and product, but of course, we also need to adhere to market dynamics. So if the prices go up, we will continue to adjust our hardware pricing. If component prices come down, we've structured the pricing this year in a way that we have a base price for services and an uplift we can bring down that uplift without impacting services and renewals, which is important. Why would we bring down prices because we continue to want to take market share. And the newer products may have lower-priced memory components, and you need to make sure that new generation products don't cannibalize other products. So you need -- from the market perspective, you want to be competitive.

Okay. And on the refresh, even if we -- '21 and '22 were really good firewall years. And as you said, customers, a, that life cycle may be shrinking. But even if we said it didn't, '21 and '22 were good years. So that to me would suggest 2027 should be an opportunity for ongoing refreshes for the entire firewall industry. So '27 from a refresh cycle should be a tailwind, should it not?

That's why we talked about the market, right? And the dynamics, yes. So I mean, I think customers make their buying decisions based on their new architectures that they have -- in 2021, 2022, it was predominantly giving employees access to on-site resources because they were all remote. So now in the new world with people being hybrid agents coming into play, more network traffic, there's going to be a rearchitecture going on. And I think that's what we see over the next couple of years to meet that demand.

Okay. Okay. And then any -- again, I said I was going to jump off of firewalls, but here I go back in again. But Sassy is promoted by some of your friends at other companies as an architecture to maybe eliminate the need for -- not eliminate, but maybe reduce the need of firewalls -- are you seeing any tension there from an architectural perspective as we move into AI?

We don't because what we see is that the world is becoming more hybrid versus more cloud. And so Fortinet's thesis is that with a hybrid world, you need on-prem devices, you need security in the cloud. But why should you move all the traffic to the cloud when you want to inspect them on-prem because the user is on-prem. And so from an architecture perspective, what we've done and can created this notion of a SaaS firewall, which is not a device, it's a market where the SASE functionality needs to sit in the cloud for remote users. But you want the same functionality, whether it's DLB, whether it's CASB out there in your network and then control that. And so our hybrid infrastructure meets both and we think that for companies that are not cloud native, that's actually hugely beneficial because it's all orchestrated with 1 operating software. You have on DD&A policy across the cloud and the on-prem environment. So a lot easier to manage.

Perfect. Perfect. Let's jump to services for a second, and then I'll open it up to the audience for questions. On the recent earnings call, there was a lowering of the services revenue 14% to 13%, so not a huge number. But can you just review the contributing factors attach rates ramping service deals, lower service activizations. Just if you could just review that, in particular, drill down on what was more meaningful -- what was a more meaningful contributor to that change in growth trajectory?

Yes. So it's correct, we brought down the service assumptions for the full year, even though we are still above what we thought at the beginning of the year, yes. So it's -- so this year has been good for product and for services. But there is -- what we saw in Q3 with a really large enterprise quarter is that, of course, enterprise customers know how to negotiate. And so we have a couple of new customers that came on -- or that bought from Fortinet. And so they -- it takes them longer to ramp.

So these were new logos.

New levels. Yes. And so we allow them to have a little bit of a lag period. Typically, for Fortinet, we have a order start policy for services to start within 60 to 120 days. And so that's not for large deployments necessarily working for customers. It takes them to distribute the devices into locations and so they have their go-live plans. So that was 1 element. We had customers signing up for larger services, deployment, and we knew that we had it in the pipeline. But then the activation -- the starting of these EAs a little bit later, and that's what you also see why we had good billings but the ARR didn't increase as much because the store data is outside the quarter. And with some of the negotiations, of course, with enterprise customers, your rate of services for the hardware stack is a bit more compressed due to volume discounting, yes? Customers buy more from you and they will say, well, I'm not paying that many services because you get economies of scale on the customer.

Yes, as any company does every company does it come...

It's actually good while it's bad news that we didn't generate as much revenue this quarter and in Q4, it's actually good news because we were signing up new customers, new logos, and we got the billings now.