Fortinet, Inc. (FTNT) Q4 2014 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to your Fortinet Q4 2014 Earnings Announcement Call. At this time, all participants will be in a listen-only mode, but later there will be a chance to ask questions and instructions will be given at that time. [Operator Instructions] And as a reminder, today’s conference is being recorded. And now, I would like to turn it over to your host, Michelle Spolver. Ma’am, please go ahead.

Thank you. Good afternoon, everybody and thank you for joining this conference call to discuss Fortinet’s financial results for the fourth quarter and full year 2014. With me today are Ken Xie, Fortinet’s Founder, Chairman and CEO and Drew Del Matto, CFO. In terms of the structure of the call, Ken will begin by providing perspective on our business and product advantages, Drew with then review our financial and operating results and conclude with our forward guidance outlook, we will then open the call for questions. As a reminder, today we are holding two calls. For those who have additional or more detailed questions, we will hold the 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 of the comments we make today are forward-looking statements. These forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those projected in these statements. Please refer to our SEC filings; in particular, the risk factors in our Forms 10-K and 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, we'll 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 and 17 of this presentation that accompanies today’s remarks. Please refer to our Investor Relations website at www.investor.fortinet.com for more important information, including our earnings press release issued a few minutes ago and the slides that accompany today’s prepared remarks. A replay of this call will also be available on our website. Note that we routinely post information on our website and we encourage you to make use of that resource. With that let me now turn the call over to Ken.

Thanks, Michelle and thanks to everyone joining the call today. I’m very pleased with Fortinet’s progress during the fourth quarter. We have very strong finish towards this year. The Q4 build in growth of 35% or more than three times of the market is the highest we have experienced in 16 quarters. During the quarter, we expand sales within our current customer base and acquired about 8,000 new customers adding to our large existing customer base, which includes a majority of Fortune Global 100. And we again were the member of last [indiscernible] service providers. So we are excited about this continued traction here because this high end customer provides better lifetime value and are beneficial to our business model overtime. Drew will talk further about this in a few minutes. On the product front, Fortinet continue to see strong adoption of our recently introduced FortiGate NP6 powered [indiscernible]. Also we continue to see traction of our FortiGuard APT subscription service and recently introduced FortiSandbox APT appliances. We win several APT deal against FireEye and Palo Alto including with a large garments service provider, a global plastic manufacturer and a U.S. based law firm. In all my year, in our security I have never seen the threat landscape more dangerous than it is now. On average, company are attacked 77 times per year. We find that 14 or 15 years ago because the cyber threat environment has changed and the new security was required. We integrate multifunction security vision change the way security is deployed and create an industry Fortinet have lack and since reception. Today, the threat environment has once again changed. We are in another security inflection point with company being enforced to make transformational decisions with respect of the network security infrastructure. In the past certain years, network security has been mostly focused on protection the network border, the point where the company connect with Internet. But today’s highly security attack are finding ways to get the parameter defense and that being initiated inside the network by means such as smartphone, USB drive or already compromised laptop or other device marked into the company. Ones our parameter reach office, if the internal data is not protected it is on risk. Protecting in network inside out is necessary. The solution is to the point internal firewall for add to the layer of protection for key network resource in an event our parameter reach. Much like a lock from a store all are safe that’s protecting the most important valuables, intrusion breaking to the whole. To deploy internal firewall, two big challenges exist, the first is performance. Internal network traffics are 10 to 100 times faster than the Internet traffic. So in order to be effective and accepted, internal network firewall must run in a very high speed also deployment must be quick and not disruptive, requiring no change to exist in policy and infrastructures. Fortinet address this requirement better than anyone in a high speed FortiASIC power FortiGate appliance. That delivered a fast performance provide protection of internal traffic and can be deployed anywhere in a network in transfer mode for easy deployment in a few second. We believe this internal multilayered protection market could be a big opportunity in the enterprise. And Fortinet’s huge technical advantages position us well against competitors. We get provision to maintain the momentum as we enter the year with the best and most prudent security platform, which delivered industry’s highest performance and skill like protecting and simplified IT infrastructure. This allow Fortinet to effectively defend so at both inside and at parameter to help our customer come back of dangers and changes at our secured environment. I feel confident in our strategy and opportunity. Our focus on constant dynamic technology innovation and security research has enabled us to quickly address the rapidly changing and hereby grow and you attend a large global based of highly subsequent customers. Both new customers and existing customers are key to our growth strategy focused on acquiring, cross selling, up selling and renewing. I’ll now turn the call to Drew to discuss his strategy in more detail and along with the finance result for Q4 and beyond.

Thank you, Ken. Fortinet delivered a fantastic fourth quarter. We are a growth company and our results exceeded or met our expectations across all key operating metrics further demonstrating that our investment strategy is working. During the fourth quarter, our billings increased 35% year-over-year to $283 million significantly exceeding our guided range of $245 million to $250 million. Total revenue of $224 million was up 26$ year-over-year, also significantly above the high end of our guided range. From a profitability perspective, non-GAAP operating margins were 16% in line with our and reflective of our continued strategy to invest the growth. Non-GAAP EPS of $0.14 was at the high end of our guided range. And finally, our cash generation remained strong as evidenced by the $30 million of free cash flow generated during the quarter. Our strong top-line performance during the fourth quarter was a result of both a healthy security market and the ongoing success of our growth strategy as well as sales and marketing investments. Our investments are focused on strengthening our enterprise sales force including key vertical teams as well as increased marketing to improve our lead generation and sales productivity. These investments help lead to a new customer acquisitions and increase large deal activity. During the fourth quarter, our number of large deal ones again grew significantly. Deals over $100,000 grew 48% to 384. Deals over $250,000 grew 43% to 137 and deals over $500,000 grew 62% to 50. We also ones again had an increased number of deals over $1 million. Also our business with U.S. enterprise resellers showed another strong quarter of growth with 43% year-over-year. We are focused on the enterprise not only because it is a large and growing market where our superior performance - our superior product performance and functionality give us an increasing advantage over encumbrance but also because the average enterprise customer has a very high lifetime value for that. Enterprise customers like service providers are very sticky due to regulatory and compliance requirements and also out of more frequent target attacking, because more require than retain a customer and enterprise customers represent rich opportunities to up sell, cross sell and renew overtime. As can be seen on slide four, analysis of our top 100 customers in each region over a five year period shows that for every $1, the customer initially spend, they spend of average an additional $5 or more over the following five year period. This was significantly higher than what we see with an SMB customer. Given the accelerated rate which enterprises are making transformational decisions about their network security architecture, the strength of our third party certified platform and virtual and physical offering versus competitors and high return of acquiring these customers; we plan to continue our investment strategy for growth. Fortinet continues to leave the trend of convergence and integration of network security offerings. All of that provides us a strong competitive advantage and not only capturing new share opportunities but in displacing encumbrance. We believe the investments we are making today will help us in the future. This includes providing opportunity to increase profitability and deliver higher returns to our shareholders. Represented of the success we’re seeing the strategy, during the fourth quarter, we acquired several new large enterprise customers from competitors where Fortinet Solutions were chosen as the core next generation firewall. Including that premier U.S. transportation company, a large U.S. retailer and a leading European financial services company, we competed against CheckPoint, Cisco, Juniper and Palo Alto in one due to our superior technology and performance. In addition to acquiring new customers, we also had success selling products to our large existing customer base, during Q4 beating our competitors. Specifically, we had several seven-figure up sell or expansion deals, where we were able to win new projects or expand prior deployments of our next generation firewalls. Among these deals, with a Fortune 20 technology company a leading U.S. software provider, a large U.S. federal agency and one of the largest Internet companies in Asia. In addition, we also won a six-figure firewall expansion deal with a leading U.S. wireless telecommunications company. We also had several cross sales deals, where we sold additional products, particularly FortiSandbox and FortiMail appliances to existing Fortinet customers. These deals are addition to the one Ken mentioned earlier and include a leader in U.S. transportation services, one of the largest Asia Pacific energy companies, a large Middle East aviation company and a large European government agency. The deals were won over FireEye, Cisco and McAfee due to our superior performance and our infrastructure integration ability with FortiSandbox for APT, FortiMail for e-mail security and the currently installed FortiGate next generation firewall products. And finally, we had many large subscription and support renewal deals with existing Fortinet customers. Our renewal rates which attract by appliances not customers remain in the mid-70% range that do not account for product refresh purchases. However, our customer retention rate is above 90% which is demonstrative above all customer satisfaction as well as the stickiness of our solutions. It also shows that we are not only winning numerous customers from exposed encumbrance we are keeping that. It’s also worth noting that our history illustrates that are enterprise and service provider customers have highest retention rates. Now turning to some additional Q4 details. Our breakdown of billion across our top five verticals remained relatively consistent with service provider at 23%, government at 12%, financial services at a 11%, education at 6% and retail at 6%. Geographically, year-over-year billings growth was strong across all regions. America’s billings grew 36%, EMEA billings grew 42% and APAC grew 19%. In regards to billings by product segment on slide five, we continue to see diversity of product billings across all segments. Our high end FortiGate products accounted for 40% of billing, a 10 point increase year-over-year and driven enterprise adoption of our high end appliance such as the FortiGate 1500D and 3700D. Our midrange enterprise products accounted for 25% of total product billing and our entry-level products accounted for 35%. As a reminder, our product billings mix varies quarter-to-quarter based on the models of products to makeup all size deals. As I mentioned earlier, total revenue with $224 million up 26% year-over-year and significantly above our guided range of $206 million to $211. On a geographic basis you can see on slide six and seven; the revenues continue to be diversified globally, which remains a key strength of our business. And the Americas revenues grew 23% to $91.6 million in price, 41% of total revenue. EMEA revenue were $85.2 million, up 43% and APAC revenues increased 9% to $47.2 million. Turning to non-GAAP expenses and profitability, during the fourth quarter, consolidated total non-GAAP gross profit margins were 72% which was slightly above our guidance. Non-GAAP product gross margins were 59% relatively consistent with last quarter, as we remained on focused on acquiring new customers for long-term value. Non-GAAP service gross margins were 84%, up from prior quarter and highlighting the value in our FortiGuard and FortiCare subscription offerings. Total non-GAAP operating expenses were $123.5 million during the fourth quarter, resulting a non-GAAP operating income of $36.8 million or 16% of total revenue and in line with our guidance. Non-GAAP net income for the fourth quarter was $24 million or $0.14 per share based on $171 million diluted shares outstand and at the high end of our guidance range. The non-GAAP tax rate for the fourth quarter was 35%. A reconsolidation of non-GAAP and GAAP financials can be seen on slide 14 through 17. As seen on slide 11, we ended Q4 with a strong balance sheet including $992 million in cash and investment, up from $964 million at the end of Q3. The increase was primarily drive by the $35 million in cash generation from operations. As I previously mentioned, the free cash flow was $30 million in the fourth quarter, were still strong the sequential decrease in cash flow reflects the variability of working capital, largely due to timing difference on collections rate relating to linearity and higher investment in inventory to support or growth. Annualized inventory returns for Q4 were 2.1 above our annualized goal of two or better. Our deferred revenue balance increased $559 million, up $126 million year-over-year and $59 million sequentially. The sequential increase was primarily due to consistent renewals and services attached to sales to new of existing customers. Finally, during the fourth quarter, we recur just approximately 214,000 common share for approximately $5.4 million. As of the end of December, we repurchased approximately 3.8 million share for a total of approximately $78 million at an average price of $20.52 under the $200 million store repurchase program that we announced in December of 2013. Before discussing forward guidance, let me wrap up by quickly running through some summary level financial results for the full year 2014 as show on slide 12. Billings for 2014 were $896 million, up 31% year-over-year or more than double the rate - the growth rate in 2013. Revenue for 2014 was $770 million, up 25% year-over-year. Differed revenue grew $126 million, up 29% year-over-year. Non-GAAP gross margin was 71% and contributed to non-GAAP operating income of $122 million or 16% from revenue. Non-GAAP diluted net income per share was $0.48 for the year based on 169 million shares. Now, let me finish with some commentary on our general outlook going forward as well as provide some guidance for the first quarter and full year of 2015. As a reminder, our forward-statements including all of the guidance provided are subject to materials cautions at the start of the call. Fortinet has a strong market opportunity and proven best-in-class offerings. Our strategy in 2014 was to invest to capture market share especially in the enterprise and accelerate growth. Throughout the year, we showed that the strategy worked. Our full year billings growth of 31% was more than double that of 2013 and more than 3X the overall market growth rate from Gartner and IDC. Our investments are paying off and we see more share gain opportunity ahead of the hidden risk environment tries enterprises to make transformational decisions regarding their network security architectures. This creates an opportunity for Fortinet, we see every indication that the trends favoring best-of-breed integrated security solutions like Fortinet will continue. This creates opportunity to us to not only capture market share from growth in the market, but displace encounter as company’s focus on the theme Ken and I noted. Thus we think we would be remiss not to continue our investment strategy and capitalize on this opportunity to capture more share of the high return enterprise market. We believe the opportunity for return on investment sales and marketing remain high for Fortinet. For all the reasons we’ve discussed, we expect that today’s investments will help fuel our longer term growth and profitability. We believe that the higher lifetime value of our increasing enterprise and service provider base driven by acquire, expand and renew strategy will result in addition growth and operating margin leveraged overtime. That being said, we are not lined by potential headwind that may occur and we have the flexibility in our model to adjust this and when it makes sense. The bank background; let me now provide specific guidance for the full year 2015 as well as the first quarter which can be seen on slide 13. Regarding 2015 wireless, it is still early in the year, we currently expect billing to be in the range of $1.65 billion to $1.80 billion, up 20% year-over-year at the midpoint. We believe this guidance reflects our confidence for a strong year given the overall high work rates delivered throughout 2014 and the challenging year-over-year comparison that we state in 2015. We expect total revenue to be in the range of $915 million to $925 million also up 20% year-over-year at the midpoint. Non-GAAP gross margins is expected to be in the range of 70% to 71%. Non-GAAP operating margin is expected to be approximately 14% reflecting our continued growth investments as well as our absorption of cost of new hires in 2014. The majority of this investment will be focused on further building our enterprise vertical sales and marketing capabilities. Our investment strategy paid off during 2014 and we believe that continued investment will result in long term growth and future operating margin leverage. And finally, we expect non-GAAP earnings per share to be in the range of approximately $0.49 per share to $0.50 per share based on an expected diluted share count in the range 173 million to 175 million fully diluted shares. Now turning to the first quarter of 2015, we expect billings to be in the range $226 million to $230 million, up approximately 22% year-over-year at the midpoint. Total revenue is expected to be in the range of $200 million [Technical Difficulty] we need to continue to invest in building the foundation for our future. We are committed to investing strategically and responsibly and expect to see margin leverage ramp in 2017. We plan to continue to provide further details on our longer term outlook in subsequent earnings calls. So in closing, I’d like to thank Fortinet employees, partners, customers and our shareholder for their continued confidence and support. With that Ken, Michelle and I will now take your question. Operator, you may start the Q&A.

Okay. [Operator Instructions] And our first question comes from Matthew Niknam from Goldman Sachs. Mr. Matthew, please go ahead.

Hey guys, congrats on the quarter. Thanks for taking the question. Drew, just a follow-up on the margin commentary, so 1Q margin is obviously, guidance were half of what they were a year ago, guiding a little more margin compression in ’15 despite great scale and maybe a little more operating leverage of some of the recent sales and marketing investment. So maybe if you can talk a little bit more about where you might see some elevated expense pressure incremental in ’15 relative to ’14 and then maybe why you think 2017 is the year where you begin to sort of inflect little more positively? Thanks.

Yeah, fair question Matthew. So we did quite bit of hiring towards the end of 204 and we’re just seeing a lot of interest from a lot of very experienced excellent people quite frankly who are knocking on our door to join the company. And so you know we had the opportunity to hire some key leaders in our vertical space then financial services, healthcare, federal and cloud and they had people follow them. And so you know you really kind of step the decision, you kind of care those people in or do you just bring them in and get them ramped up and that’s what we saw and that’s a little bit of - that’s really baked into the guidance for next year and trying to giving us a little room until 2017, because we are seeing a lot of interest. If you look at this market, you know the overall trend, there is huge tailwind here on security. This is the lot of interest. People really are buying products, it’s not really would you like some security with your network gear, it’s just not that anymore, securities now the problem dimension the people are focusing on, you know we have best-of-breed technology that sells really well. That when enforced by the people coming in, they like that story, they believe that’s the great opportunity for them to sell and quite honestly make money. So that’s how - that’s really how that is playing out. Also there was marketing team built that will continue to play out. And you know we’re just you know we can’t exactly predict when we’ll see the exact benefits of that because these are really focused order enterprises, middle order enterprise, the cycle times of those are little less predictable and so we’re giving ourselves a little room and just being prudent with shareholders quite frankly. You know but I would remind you that you know we really are committed to longer term growth, again remind people also that our spend is clearly on the sales and marketing line, we’re scaling G&A and R&D there is - we are up building out a big ramp there or anything like that. So you know we’re very focused on enterprise, building up the verticals and building marking effectively.

Got it. Thank you.

Thank you and our next question is from Keith Weiss from Morgan Stanley. Mr. Keith, please go ahead.

Hi, this is Melissa Gorham calling in for Keith. Thanks for taking my question. Question for either Ken or Drew, just on email, the strength of email was very impressive this quarter which seems little bit you know maybe countering to that just given the macro deal points that we’ve seen. I’m just wondering if you could maybe provide some color in what you’re seeing in that region, is it improved product positioning or perhaps better execution you know better sales capacity or just any color on what’s driving that strength would be helpful?

Sure, Melissa. We think about it is you know there is - obviously the security tailwind right but I think your question is, will that - that’s global, especially given the economic condition. The products again we’re focused on the enterprise 3700D, 1500D are doing very well in the enterprise space, that’s the first thing. The second thing is a little bit of what I just said to Matthew, it’s about the people. We had a couple of leaders come in early in the year and they’ve done very well in putting a new team in place. It’s really have a new team in place, they knows the space, they knows the customers and really see the great opportunity to make money and they’ve been performing very well. And so I really have to strike it up the execution. The marketing there is also been that very good. I think they expect lively, very focused on regeneration and work extremely well with the team. And so it’s really a model that we’re ambulating globally and really that’s what putting the wind in our sales for the continued investment as we look out to 2015.

Melissa, this is Ken. The other point I want to add is what the investment we made in some other technology product NP6 and also as I mentioned the space send into more protect both inside and outside, I mean protect their internal network that’s giving us huge advantage we have which is a FortiASIC based high speed performance gateway internally compared with the way they secured a border in the last 20 years. So that’s give us huge advantage over competitor and also huge opportunity going forward.

Okay, great, thank you. And then I am just - one really quick question. You mentioned some contraction with the FortiSandbox appliance, I am wonder if that starting to have a material contribution to revenue and then how we should think about that ramping into next year?

See, I think the way to think about it is I think most people there is kind of the FortiSandbox and then is the virtual offering. Lot of people really are buying the integration story in terms of the bundle. And so you know it is - it’s not a huge number relative to the overall number of Fortinet, but if you think about how at least the sale of other product in the integration story that’s really where the value is. You know people are buying that you know and integrates well. Technology, security technology is obviously converging on the network devices.

I agree with - that was true, the key word is only the protection because all solution not only put a detection but also working with FortiGate really protect - the customer protect the data, so that’s different in some other company, we can only detect not really take action to protect. So that’s protection, the total solutions actually attract lot of customer to us.

Okay, great, thank you.

Thank you.

Thank you and our next question comes from Brent Thill from UBS. Brent, please go ahead.

Thanks. Drew, just on the operating margin, you have to go back in the model five years to go back to time where your margins were at 14% and in 2010 and ’11 you were putting up 30% growth with mid - above to mid-20% operating margin. So I guess the question is you know why do you feel like you have to go that low especially going below what you did in the last fiscal year on the margin, what kind of gives you that kind of confidence to go that the sustainability of this investment to yield the top line?

Sure, Brent. I think we’ve seen in 2014 that our investments are paying off you know the focus on really acquiring customers and driving value over the time is our strategic approach. We see a unique opportunity to capture share at this point. The market - the security market is in a transformational state right now, people want to us breed. We have that. And that really as reinforced by the people we see interested in joining company. We’re doing that strategically, it’s also reinforced by the people coming in. And so we just think it’s a very good from our perspective and we think it paid also and we just have some more work to do which is really the drag on the margin if you will for the next year.

Also yes, there is a sometime delay compared to when you get sales on board and also when they can close the deal. We can see during 2010, ’11, ’12 the hiring sale people or the sales capacity is the half compared to the top line growth. So that eventually we can’t [Technical Difficulty]

[Technical Difficulty] is across the board, I mean that you move shifted toward sales and marketing, more toward here or both?

So it’s sales and marketing.

Its most, but R&D also sometime need to see more long term investment that investing [indiscernible] ASIC level sometime it may take like a five year to see the return.

Yeah, that’s not over, our R&D investment I think it’s consistent with what we’ve been doing historically. I think really where the change and it’s with over and above with what we’ve been doing early on and the additional investment in sales and marketing.

Yeah, it’s what I said to Matthew earlier basically with the investments on sales. As a percent of revenue, the investments are on the sales and marketing side, R&D and G&A really scaling 50%.

Got it. Thanks.

Okay, thank you and our next question is from Sterling Auty from JP Morgan. Sterling, please go ahead.

Hi, this is actually Ken [ph] is for Sterling. One question, I was wondering if you could give us a sense of what the impact of growth would be if you would actually taper off that investment those marketing?

Sure Ken. I mean the way we think about it is I mean you could - to be fair; you could grow probably without significantly increasing sales and marketing. I think the reality of it is the value really is acquiring market share at this point in time. Again it’s a transformational stage, it’s a unique opportunity for best-of-breed security companies to focus on security and provide it, you just you know selling a little bit of security with your network here just really doesn’t play anymore. The relations are open for us to grab, that’s what they are doing. We think that’s a great investment, because overtime there is high CLV which is what I was getting into - that’s what I was talking in the call where we see a higher CLV obviously in the enterprise space than you could see in the SMB space. So this is a bit of a transformation for us, we are about way through it.

Yeah, that’s actually after than two, you know could we grow in this environment? Yes. Could we grow twice as fast as what we grew last year, probably not, our growth doubled year-over-year. The other thing is to as we talked about in our commentary is that really the investments we are making today are really to help us in the future, not necessarily just today’s environment that to grab with the right customer that bring very healthy lifetime value that will help us you know four or five years out.

Okay, thank you. And I was also wondering if you could give us sense for what cash flow might look like give this trajectory?

Yeah, we don’t really got on cash flow that I can give you couple of the key items if you will. So for FY ’15 for CapEx, we expect 40 million to 45 million and for tax somebody always asking the cash tax rates, I’ll just kind of give you a range of 20 million to 30 million.

Okay, great. Thank you very much.

You’re welcome, Ken.

Thank you and our next question is from Walter Prichard from Citi. Mr. Walter, please go ahead.

Hi guys, this is Jim, actually I am for Walter. Thanks for the question. The past few quarters, you guys have shown a great improvement in DSOs, what drove your DSOs higher, was it just larger customers for DSO?

No, you know the - really it was linearity, it’s really just linearity. And what happened was the quarter wasn’t back unloaded in terms of like being last couple of weeks. But really the last part of November and the early parts of December was where the deals are seeing, you know quite a bit of deals came in. And in the prior couple of quarter, we’ve seen a smoother linearity ramp if you will, but that’s really, there is no other story there, it was not a - certainly wasn’t a preliminary type of quarter anything like that. It was I would call kind of smooth along the way and very nice in the last couple of weeks kind of pre-Christmas part of business.

Gotcha, thanks Drew. Can you also talk about how many solutions per customer you have as well as any commentary you can provide on sales productivity on here?

So let me take the last one first. On sales productivity, I would say people are doing very well, people are performing generally at or better than expectation. There is at least - there will be at least the dull curve on that statement let’s say, so we’re seeing a nice - we really are seeing nice productivity goes back to my only comments I think people see very prudent opportunity in the space that is sales people are not only here but coming into the company. That is better as they get more tenure, there is a high coloration to entranced relationship and develop relationships in security to higher performance. In terms of the overall products, you know we do see interest in people really kind of buying the bundle if you will and that you can look at the billing and revenue slightly than billing is not part of the explanation, you know it’s going to differed revenue, because obviously there is a higher percentage of people buying the virtual offerings and subscription based services and technology.

Yeah, also we offer quite broad product, so that’s where the up sale, cross sale opportunities also very big. That’s where fully scheduling at the leading a lot of the deal and then customers they didn’t see the Sandbox in, see the FortiWeb, FortiMail, some other solution that they needed. And so that’s also like I mentioned early, how to secure your internal secure the datacenter to server, they use sort of the common, so deploy inside the company, we also see a lot of opportunity this way.

Great, thanks.

Okay, so we’ll take our next question from Jeff Kvaal from Northland. So Jeff, please go ahead.

Yes, thank you very much. Another question - another clarification, the clarification might be easiest, did you say that the long terms operating margin target that was 20% or 25%?

20

20, okay. Got it. Then the long term question is, I am little concerned that the market is getting a bit more competitive, the OpEx here we’ve discussed, did it sound like the gross margin is down a little bit, we talk little bit about DSO, some of these things are not things that some of your other firewall competitors you think too much in the market, but - and so where is going to little bit more for me to get that incremental market share, my overstating things, how many things are true?

Well you certainly welcome to your own, the way we see it, I wouldn’t say that’s true, I think when you are talking gross margin, we’ve been trend there. Again you know we see a high value in acquiring customers and retaining them. We have a very customer retention rate, if you look across our more than 200,000 customers it’s a very high 90% plus retention rate. There is a lot of value in acquiring customers and monetizing them overtime. That’s quite a bit of the strategy. We also, I think it’s very that the market is a very good fertile opportunity for us and that’s really where a lot of the growth we think have come from and will continue to come from given a best-of-breed products in our story around the ability to convert security technology on a network devices. So that’s really at and keep in mind also the markets growing according to ITC you know somewhere between 7% to 10%

The other orders seems only to the model really when we grow faster, you can see the percentage of the product revenue little bit bigger compared to like little slow growth with the service that come up better. So we have a model, the product revenue tend to growth 60% and the service revenue tend to grow like little over 80%. So that’s when the product revenue growth faster, which is also the leading indicator for future service that tend to have a margin little bit.

That’s right and you also to point - you have higher commissions along the way which there is another way to kind of get into sales productivity not we talked about 70 but I think it’s other way actually a higher commission expense in Q4 as people are performing very well. DSO, I would say Jeff that I don’t think the DSO had anything to do with the market going forward. Again I - you know it’s really talk in the first couple of weeks in December, so I don’t think that’s have no long.

Okay, and then finally you gave yourself, something you said you gave yourself a little bit of room and guidance on the develop line to OpEx line in particular or with across the board?

No, I think my reference was to I think someone asked me the question about why the margin in 2015 and what do we see going forward. And that was really about the ability to make key hires where in the right people become available. Just over the last year is that the people make a very big difference. We really see saving a productivity out of new people with experience you know experience in this market with customer growing after and the ability to sale. So we are seeing - now that’s what we’re really doing and then the good people follow them in groups. And so it’s not a tired ramp, it’s people with a smooth ramp, they tend to come in bunched.

Thank you.

Okay, thank you and our next question comes from Jayson Nolan from Robert W. Baird. Please go ahead Jayson.

Thank you. Congrats on the quarter and just a follow-up on the sales and marketing expense Drew, it’s –you think this is mostly a head count as opposed to channel incentives or advertising?

Not absolutely, now what we do is, we have been building a lead gen-engine, but I would even point to that we had talked about the year, I think that’s one of the things I said is building out a lead gen and then you go to multiple assets, is a bit transformation and that takes time and submit you probably get it right, you get all the handouts right, to get metrics right and to kind of see where the best-of-breed come from. And I would say that we’re actually starting to see the front end of that, that feels like really like going forward I mean almost back. Jeff’s question, do you think the indicators are something softening or lack. In fact I would say it’s the converse is true. What we’re actually seeing is improvement in the overall lead generation and the qualification that believes the quality, it believes if you will the way we measure that. And we are actually getting a good beat onwards as they are coming from and being able to kind of narrow and focus on I think even kind of improved and investment profile there. Again you need to get yourself a little time to build that exactly right and make sure you know you got your meshing down correctly for your business, but we see very good results on that.

On the FX side, could you confirm that you price mostly in U.S. dollars around the world and have you seen any headwind or expect to see any headwind there?

You know, we do price in U.S. dollars, have you seen any headwind, the answer is probably not, you now certain not incur to us, I am sure there is little bit of discounting here and there. I don’t think anything abnormal. It has come up, you know will be a headwind, you know I think that really depends on how to fill the gaps but we haven’t seen a lot of that, what we really tell people is that our margin agreements address some variability in FX I mean you know people are getting this back money or margin when the euro was at $1.45 or $1.50 and we remind him that when it’s closer to $1.10. Also the - you know the focus on security is very high and so there is a bit of pricing leverage in the market. That been said you know just really hard to predict what will happen going forward.

Understood.

And we do remind people what goes up, goes down and vice versa by the way.

Thanks a lot.

Okay, thank you and our next question comes from Gray Powell from Wells Fargo.

Great, thanks for taking the question. Just a couple with - if I may. So obviously we’ve had a very positive spinning environment 2014, how sustainable do you think it is and in directionally, do you think that broader network security spinning growth in 2015 can neither exceed the PC soft in 2014?

Well, if you are asking the question about the market as a whole, I think we would have to try to pull it back the IDC Gartner numbers which I believe are high single digits, maybe 10%. You know obviously we’ve given the guidance, we upgrade, so we wanted to really get off of that. You know I think the answer is more qualitative about we do see opportunity out there generally beyond just market growth, you know give the best-of-breed technology and our story of that convergence of security products on IT and sell security for us versus kind of network plus security and then add on. And that’s really how we resonate in the market and you know if you think about all the security issues out there, I am sure if it’s only a problem in that thinking about your network here right now, you are thinking about securities and that’s what we leave it.

Okay, that’s helpful. And then maybe I know lots of the conversation been focused what was the enterprise, but there is maybe a question on the SMB side of your business. How did you view the competitive environment there, last quarter I think you stated that you’ve been seeing some weakness from your competitors, so has anything change there and so how should we think about growth in that segment versus rest of the business?

Well I think we gave a number for channels growth of - yeah.

I mean I would say, we’ll see any change and I think that we can change in the SMP part of our business, I mean it’s a very well run part of the business you know driven by the channel very easy I think to be running with the strong advantage there, so nothing really changing there.

Okay, thank a lot.

Thank you and our next question comes from Jonathan Ho from William Blair. Jonathan, please go ahead.

Hey guys congratulations on the strong quarter. Just wanted to start out with a quick question on the OpEx side of things, in terms of currency, I just wanted to understand sort of the dynamics there and whether the OpEx side would maybe benefit from currency and how that sort of factors into the ’14 guidance?

Well, it’s - I mean there is a bit of a benefit, we do have some quite a few has in Canada and some in Europe obviously, so we’ll see that benefit. But we have factors in the guidance.

Got it and then just in terms of the broader traction that you are seeing in the enterprise city like do you feel like putting at this point is being invited to many of the big causes that are taking place or just still relatively early stage. I am just trying to get a sense from you in terms of the traction that you’ve gotten particularly with the reseller channels and the ability to get invited to many of the bigger competitions that are taking place?

Great question Jonathan. I think we’re certainly getting valid more .What I can absolutely say is you know without the investments we’re making, we probably - we would be hard to make that statement. I think it’s - we no longer here, we just have part of conference and what I heard time and time and time again from the partner well that’s no longer reported who. And really the ability to focus on them given the tools and training that they need on the products and give them the sales - help them with sales coverage and marketing and leads is a key factor and getting to the table. So you know I guess somebody answered the question is we’re getting it more, do we get in mall, I don’t know. You know hopefully we are getting more and more as we go forward that’s the idea.

You know Jonathan, also it depend on vertical, some vertical we probably have better market share like in education and some of the retail, some other vertical is letting more Greenfield which we - and we started build up, some great sales was there, so that’s also we mentioned lot of our existing customer we seen special big enterprise that the initial buying it’s the long term, it about five years of the initial buying. So that’s also having to the existing customer base and up sell, cross sell, also we see a lot of opportunity, that’s which also need a lot of sales coverage. So that’s we see a lot of potential. Also we mentioned like a multilayer security, securable in the broader and the inside also has a huge opportunity for us.

Got it and just one final clarification, when you guys talk about sort of the dynamic with greater lifetime value with the enterprise that you are pursuing, is that sort of one of the major factors that ways into your decisions to justify making the investments now just from the perspective that maybe as you win these customers overtime you’ll just see a significant pickup once you can land and expand within those organization?

Jonathan, it absolutely is, you know Ken to talk about the strategy of the ability to our products are expand the products that to create that full opportunity overtime. But before you guys ask everything, I would point out that we have a very high customer rectification right that I also mentioned really which is 90% plus. When you think about those factors and getting some tenure sales people in those accounts, we provided, we think it’s a very good chemistry to provide very nice returns overtime.

Yeah Jonathan, that’s a few parameter we started add in to measure effectiveness and also performance is really the customer attention. In the past, we only measured a renew rate which only measure only effectiveness and also performance, is really the customer attention. In the past, we only measured a renewal rate which only measure per box renewal, now the retention we’d also helping to see even the customer base on new box, customer is a retention rate but not in a renewal. The other parts really the long term value of the customer from the initial buying tracking for few years than how much keeping buy in the next few years. So that’s the new measurement we see a huge value.

Great, thank you.

Thank you and our next question comes from Erik Suppiger from JMP. So Erik, please go ahead.

Yeah, congratulations on a very good quarter. First off just curious, you talked about the internal market opportunity, was that much of a factor in the December quarter and how big you think that market could be relative to the parameter market?

I in the last few quarter you see a lot of news, company do have the firewall and another security device project even the connection new cut in pushed inside, so that’s we see a lot of feedback from customer, now they need to protect their server, their important data inside the company, so that we see a lot of opportunity and this combines with a new FortiASIC NP6 based appliance which has high speed. We see huge protect and also demand for this one. I think still in an early stage because the market we need to educate it about multilayer security internal compared to test security parameter, but it’s a new opportunity but we see a huge potential and a lot of customer were interest in this. Like I mention, there is two key challenge here, one is the internal speed 10 to 100 times faster than the way the connect to the internet. So the - I mean the security gateway has to be fast enough to match the speed of internal switching device. The second deployment has to be more quick easy not intrusive and they don’t change any policy on infrastructure which need to dropping within in a few second in the transparent mode. So these tools are key advantage compared to competitor and that we see the huge potential in the - for this new approach.

Okay and then do you - you just on the margin, on the operating margin front, can you give us a little sense for kind of the pattern you would expect from operating margins in 2015, if you are staring at seven and it’s going to 14 for the year, is it going to a liner progression upwards or is it kind of take a stair step from Q1 to Q2?

Yeah Erik, kind of hard to deal with this point. You know I get back, obviously there have to have margin, you are going to probably exit year are harder that we start in the year, I’ll give you that. That’s mathematically that has to work to get to 14 from seven. But why is that whole to know, if experiences taught us anything that given ourselves the opportunity to get the right people in the door and you know if they bring people in with him, it just - it can spending early or late. And so I think it’s really hard to get people too - you know be - wouldn’t be good idea to get people too focused on that as kind of pursue that opportunity. But we’re pretty selective on afford a culture I you will and who is a good set. You know we look for certain type of person and you know when they are available, they tend to have people follow them. That way on - about that’s really some of the - some of spot there and just being a little careful on trying to provide a ramp through the year.

Let me ask you just, would you expect end the year significantly about 14%?

The entire year or in Q4?

Q4.

I think unfortunately we can’t, we are not providing guidance on a quarterly basis, I mean as Drew had mentioned, obviously we need to increase for the year by may not be stair stepping perfectly each quarter the next.

Thank you.

Thank you and our next question comes from Shaul Eyal from Oppenheimer. Please go ahead.

Thank you. Hi, good afternoon guys and congrats on strong set of numbers. Drew, probably a little bit of the long terms question is you started providing some color about fiscal ‘16 and ’17. And we look into the breakdown between product and subscriptions obviously both are really doing well like now, but 2017, who could you envision that the breakdown between product and subscriptions heading towards, any color you can share with us?

Yeah, so Shaul, we are not really - we don’t really guide product versus subscription mix. You know I would qualitatively, we are - believe we think about it as we somewhat agnostic to how people buy you know virtual and physical. And it’s also hard to predict how that’s happen you know to service provider and other you know sales do well. So you know I don’t it would be useful to provide that, but we do see kind of an overall market growth opportunity that we’ve talked about and beyond to really exploring the common territory. It’s just hard to know who the people really going to buy or how to predict.

Got it, that’s fair. Thank you so much.

Thank you and our next question is from Imtiaz Koujalgi from Deutsche Bank. Imtiaz, please go ahead.

Hey guys, thanks for taking my question. Just a follow-up on the previous question, if you look at the products and services that’s been trending more and more toward products for the last couple of quarter, can you comment on the services given that mix shift towards products - product that’s driving that?

Sure, Imtiaz. I mean I think we talked - I mean from a - let me get I mean in the products and segment, just think about this, you know your service revenue really comes overtime, so higher growth model, you know that revenue gets differed and so you are going to see waiting to product keeps upfront, which is reflection of new installation. Think about like that. And then you could differed revenue grew nicely quarter-on-quarter and year-over-year, I think we’ve mentioned those numbers on the call. And so you know that’s really the point there. So you’re going to kind of see that product line lead the growth in the company and then the services in subscription revenue follow overtime. So the change of differed is a good metric to kind of allocation that, right. Well I will just remind you that the differed revenue balance at the beginning of the year is a much higher than the quarterly revenue number when you look at the growth rate. In terms of products themselves the 3700D, the high end of the products 3700D, 1500D have done very done. Ken, anything to add on products?

I think you know I like to see the seven something take a few years to starting see some of the benefit even look at the when we go five years ago that time probably only 200 not they are building about another, so that’s where - but five years ago, some of the part is still buying the service, right so that’s way the product the leading indicator was the product in the lifetime value is probably more towards the service long term wise. And that we see the huge value of keeping that expanding the product sales into the customer. I think the demand also speak the same and so the long term value is very huge on the potential service revenue.

And then if I could add few tap is that part of your question was a tax rate of services and…

Yeah.

It’s still for the FortiGate products, the majority of people who buy the product, the part of our subscriptions in bundle versus buying one at a time. And so it felt hard to - I mean our tax rate is very, very good, it’s hard to track it overtime simple because most buy the bundle upfront.

Got it and then the APT product, is that growing product or is that a subscripting attached to the product or is that time saving to drive more product revenues?

It’s both, yeah we have an option, so we have reported FortiSandbox appliance which be a product sale with the subscription that come top of that or customer can use FortiGate device with an APT, it’s one of subscription, so that which has been…

To be at a bundle well, and you know again if you go back to the model, the graphic we showed on the call, you know it explains the strategy where you really acquiring customers whether it’s - we’re kind of agnostic again, we think it it’s a platform whether it’s hardware or subscriptions physical and virtual which really is basically installing relationship that you could add on more things overtime. And by looking at that you know you think of a high CLV building ourselves tenure relationships creates another ladder verity of ladders including the up sell, cross sale, renew, resale is important concept for us, thinking at that way, you know people talk about firewall refreshes and so you think about resale, that’s why we offered retention rate. And then that also leads to kind of another ladder if you will of tenure, right because if you look at customers overtime, the ability of extend that time also add value in terms of how you think about the company right retaining customer up selling and cross selling them, renewing them, reselling them, all those things go into that field along with retention.

That’s very helpful. One last one if I many. As Ken mentioned a number of new customers this quarter, 8,000, it seems like high number, I’ve that heard number from you guys before. How is it compared to the number of customers you typically acquire in prior quarters?

It’s about consistent, it’s a new metric that we’ve given, you can go back if you have time and - you can go back in our Qs and see how that the number of customer has grown, but it’s relatively consistent, I think now is the quality not just the quantity of customer. So I think it’s fair say that you know if you look at it through large deals and other metrics that we gave in our business had a higher amount probably towards the high end in enterprise.

Yeah, so that’s the good point. I mean Michelle had a good point of that just maybe going back and taking a look at some of the larger deals and the growth there because it always shows a shift into the type of customer that we’re looking for.

Got it, very helpful, thank you very much guys.

Okay, thank you and our next question comes from Rohit Chopra from Buckingham Research Group. Sir, please go ahead.

Thank you. Thanks for letting me ask some question here. I had three questions for you. Drew, just maybe a clarification first on the sales marketing spend, is that still focused in North America or there are other areas where you think or other regions were you think you need to spend and maybe APAC didn’t have that growth, is that a place we need to invest?

Well the - maybe we start with APCA, I think that’s easy. And the first one I think we’re still growth 2X the market there, so we’re grabbing shares, so that’s the good thing. The second part of the question is, yeah, we probably do need to make a few more investments there. We actually did a bit of leadership transition throughout the year and I think that’s part of the explanation there. So one of that more was probably towards more the first half of the year and that region is starting to pick up and actually seeing nice return. Again suggesting the right people really matter in space, that we really believe in that. And then you know the second piece happened later and the second transition happened later. So that’s APJ, so we’ll continue with that there. We will continue, we will bet globally kind of add scale but in the U.S. yeah we are really building up the marketing team and the vertical, a lot of that happened at the end of Q4 you know towards the end of the year which we talked about and we will continue to look at opportunities there and globally as well as we see opportunities.

Then when you did highlight some of the investments that you are going to make at the end of your prepared remarks, you indicated some flexibility, what would cause you to maybe pullback on the investments, what are the some of the - maybe some of the markers that would make it bit more cautious and you can pullback and maybe we feel bit more leverage in the models?

You know I think at the terms of pulling back you know obviously the things you are going to look at you know a significant shifts in the market change - the change in the market. Then also you know I mean really something tragic in the global economy you know would obviously give us some level cause as well.

Okay and then the last one is more for Ken and Ken just more at a high level, you guys have been taking a lot of share from incumbents and I know you mentioned on this call and almost every other call, but where do you think we are in that cycle, are we on the back half of that or we on the - there is still a ton of room and the reason I ask you Ken is because when I look at your - look at Juniper, I was going to say, your company but when I look at Juniper, and I look at what they have left as far security, there isn’t very much and that just one example. But I just wanted to know where you think we are and the whole game of taking share from incumbents?

I think probably most depend on a vertical space little bit. I still see a relatively probably huge potential in that space both because there is mobile device and also the new infrastructure FortiRG is another potential there. So that’s but also will be lot a - going forward. Other part - on the price is relatively Greenfield specter some of the new vertical for us and the past the secure internal on the product we have huge advantage, that’s secure inside enterprise is fairly new market opportunity, potential can be huge, so also have huge advantage. On SMB, I don’t see changing much as a quite consistent in a last few quarter or even few years. We consistent and customer using some new technology like our new system-on-chip to have a better like a performance function cost compared to our competitor, so we also grow faster to gain market share in SMB, but the long term value to potential growth with this well is in some other down the price and also they being carried which positive in some stage to ramp up. Also we mentioned the transition of changing started happening in the space the traditional way of secured boarder or secured fixed desktop machine whatever is no longer enough, it’s really the how to secure the mobile device, how to secure inside the parameter if fairly the new trend, which we have huge advantage. And we are the only company, no more secured company build their own basic system label which can give a lot of performance boost and give a lot of additional function compared to some other competitor which have some softer expertise.

Thanks Ken, Thanks Drew.

You are welcome.

Thank you and our next question is from Daniel Ives from FBR Capital Markets. And Daniel you line is open. Mr. Daniel, your phone be muted, if you can check your mute button please because we’re unable to hear you at the moment. Again the question is coming Daniel Ives. I am assuming, he step the way, we’ll take our next question from Aaron Schwartz. Please go ahead Aaron.

Great, good after. Just two real quick questions. If I open the competitive question, Juniper been downward but it seems that that has accelerated to the downside, is there anything more specific you are doing to target that revenue base, you are obviously the more natural company from share gains. And then secondly, Drew, can you just walk through the inventory that seem to have a bit larger negative impact on the cash flow statement and just wanted to get thoughts on what happened there and just how you are planning inventory into next year? Thank.

Right, why don’t I take the second one first Aaron. So inventory, yeah build up little bit. I think when we’re obviously building to make sure you know we could serve as the customer that we see, we also don’t want to run off early in the quarter. So there is a bit natural ramp of that. And one of the other things we’re experiencing is along of new product introductions you know which you have to kind of buy, you have to buy general inventory, you have to ramp up some of the inventory, we’re in the middle of verities of new product introductions I’ve explained part of it. But I think most of trends to be the organic side, well we are seeing a little more on what I would say is almost non-organic is we are seeing some issues with the port and the port where there is work slowdown, basically work slowdown to get things off the boat. And we literally we’ve had inventory sitting on port for a while, so being a little cautious in terms of having the ability to have product available to serve our customer when need. And then is also a long lead time on chips from one of our suppliers, that extended also five months now. And so there is a bit of long lead time, so you kind of building up and ramping being able to support the growth that we need. And so it’s a little more - little tougher to predict that and we are just trying to cautious and make sure we can service our customer. We generally want to product ones they order it, we’re trying to avoid backlogs to be fair.

Yeah, seems for the first question, we don’t particularly see gaining share out from Juniper, sometime we see gaining more share from some other software based network security vendor. I think when from that and then now we have to reach and building some ASIC based firewall, but so they have some performance advantage compared to modest software competitor, but I have to say they are later now and keep the innovation of some of the new function. But on other side, our advantage most of them are performance and the new multifunction platform and which has much better like a deploy into lot of carriers in some high environment and also the system also have lot of advantage some SMB branch office, so that’s where we see a lot of market share gaining as some of kind of advantage using the performance probably more towards them of a software based network vendor.

Terrific, thank you very much.

Okay, thank you, so this does conclude our Q&A session for today. I’d like to now turn it back to Michelle for any closing remarks.

Thank you John. Thank you everybody for the time you spend today with us, it’s obviously a busy and busy week. If you know, we have a second call scheduled at 3:30 if you dive deeper into the information we gave you, please feel free to call back in and you can ask additional questions at that time. And that’s it, so for who you want to call in, we’ll speak to in about 45 minutes. Thank you.

Thank you for the time and support.

Okay, ladies and gentlemen, this does conclude your conference. You may now disconnect and have a great day.