Fortinet, Inc. (FTNT) Q1 2017 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the First Quarter 2017 Fortinet Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we'll conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions] As a reminder, this call is being recorded. I would now like to introduce your host for today's conference, Ms. Kelly Blough, Vice President of Investor Relations. Ma'am, you may begin.

Thank you, operator, and thanks to everyone on the call for joining us on this busy afternoon to discuss Fortinet's financial results for the first quarter of 2017. 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 perspective on our business. 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, we ask that you please be conscious of limited time and make your questions brief to allow for others to participate. For those who have additional questions, we will be holding a second conference call at 3:30 PM Pacific Time. Both calls will be webcast from our investor relations website. Before we begin, I'd like to remind you that on the call today, we will be making 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 most recent Form 10-K and Forms 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 11 and 12 of the presentation that accompanies today's call. We also encourage you to 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, the slides that accompany today's prepared remarks, and other important information about the company. A replay of this call will also be available on our website. I'll now turn the call over to Ken.

Thank you, Kelly, and thanks for everyone joining today's call to discuss our first quarter 2017 results. In the first quarter, Fortinet delivered billings and revenue growth that exceeded our guidance, and continued to surpass the market growth rate. We continue to improve our profitability. And as we have discussed in the past, we plan to steadily increase our operating margins to create additional value for our shareholders. In the first quarter, we saw strength in the large multi-product deals, demonstrating that the security fabric architecture is continuing to gain mind-share and market-share for Fortinet. Our customer and partners recognize that our competitors' multiple point products and loosely integrated solutions do not provide the breadth, depth, performance and orchestration needed to address the demands of today's digital economy. The Fortinet Security Fabric is cohesive, multi-product platform that works together to detect, monitor, block and remediate attacks against the entire enterprise surface area, responding to our customers' need for a seamless, tightly integrated approach to security that protects all points in the network. Enterprises do not have to sacrifice their network performance to ensure that their networks are secure in this highly competitive and evolving landscape. Our latest next generation firewalls, the FortiGate 7000 series with the 7030E, 7040E and 7060E deliver ultra-high speed Next Generation Firewall and advanced threat protection in a flexible chassis-based form-factor, based on the latest CP9 security processor. Many security vendors detect threats, some prevent them with integrated solutions, but only Fortinet excel in all five stages of network security: detection, prevention, integration, performance and value. As we continue to land and expand into some of the largest enterprise corporations and government organizations in the world, we again added more than 10,000 new customers during the quarter. This brings the total to more than 310,000 customers worldwide. Broader adoption of the Security Fabric also result in increased sales in the quarter of non-FortiGate solutions. During the quarter, we were pleased to announce that several leading technology companies joined the Fortinet Security Fabric-Ready ecosystem, including Cisco, Hewlett Packard, Nuage Networks from Nokia and more. To date, Fortinet has 22 Fabric-Ready Program Partners, representing a cross-section of leading information technology providers whose offerings are tightly integrated with the Fortinet Security Fabric. This open approach enable multiple vendors' security solutions to share actionable threat intelligence and mitigation information in real-time. We are also pleased to announce early this month that Fortinet has extended the core capabilities of our Security Fabric architecture to enable businesses to experience the same level of cybersecurity and threat intelligence in cloud environments as they do in their physical networks. The latest enhancement of the FortiOS 5.6 offers customers the ability to manage security capabilities across their private, public cloud and software-defined wide area network, SD-WAN, environments. Early this month, Fortinet and Vodafone announced a new global relationship to provide next generation security solutions to enterprise customers by embedding Fortinet's high-performance virtualized security solutions and integrated Security Fabric architecture within Vodafone's core network products. Our strength in cloud offering is driving demand for on-premises implementation of the Fortinet Security Fabric. By providing the highest performance, most complete and well-integrated solutions, the Fortinet Security Fabric has positioned Fortinet as an innovator and the market leader. I will now turn the call to Drew, to review our first quarter financial results and forward guidance.

Thank you, Ken. Now, let me now share our financial results for the first quarter, which can be seen on Slide 3. Fortinet had a strong start to 2017 with billings and revenue exceeding the high-end of our guidance ranges. Billings increased 22% year-over-year to $403 million. Reflected in this number is approximately $12 million from a single deal closed in the quarter. Approximately 70% of the revenue from this multi-year contract was deferred into future periods. Revenue of $341 million was up 20% year-over-year. Revenue growth was driven by strong performance in North America, particularly in enterprise, demonstrating ongoing improvement in sales productivity. As Ken mentioned, we saw success in large deals and in multiple product deployments, demonstrating adoption of the Fortinet Security Fabric. Deferred revenue grew strongly again to $1.098 billion, up 31% year over year, reflecting the business shift to more margin rich, recurring subscription and service revenue. Sales of enterprise bundles were again strong in the first quarter, driving higher-priced and higher-margin recurring revenue over time. Our non-GAAP gross margin was 75%. Our strategic focus on driving sales of higher value, higher price, and higher-margin recurring revenue streams, such as services and virtualized product offerings contributed to our improved gross margin in the quarter. Non-GAAP operating margin was 13%, and non-GAAP earnings per share were $0.17. Finally, we generated $116 million of free cash flow during the quarter, an increase of 65% over the first quarter of 2016. Our first quarter results benefited from customers' recognition of the value, performance, and comprehensive security coverage provided by Fortinet's Security Fabric. This was evidenced in the first quarter by continuing strength in large, multi-product deals, and sales of non-FortiGate products to enterprises. The number of deals over $100,000 grew 20%, deals over $250,000 grew 15% and deals over $500,000 grew 31%. The majority of our large deals were attributable to the key differentiators of the Fabric, particularly manageability, orchestration and integration across the enterprise. For example, in the aforementioned multi-million-dollar, multi-product contract with a large educational institution. Fortinet's technology beat out the incumbent and other competitors not only due to performance, but also to the manageability and integration capabilities that the Fabric provides. In another first quarter deal, Fortinet is being deployed in a large European financial institution, whose incumbent security solution was not scalable, powerful, or manageable enough to respond to its growing business and larger attack footprint. The customer chose Fortinet Security Fabric for our ability to provide internal segmentation and advanced threat protection in the context of a scalable, well-orchestrated, high performance solution. 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. The latest enhancements to the FortiOS enable customers to manage security capabilities across their cloud assets and software defined wireless access networks. We also announced this month the launch of FortiCASB, a cloud access security brokerage providing customers and partners, with an interface to gain visibility and control over SaaS applications through the Fortinet Security Fabric. Turning to our quarterly sales results, the breakdown of billings across our top five verticals was: service provider at 21%; government at 15%; education at 13%; financial services at 11%; and retail at 9%. On a geographic basis, billings in the Americas grew 27%, led by the United States, which outpaced all other regions in the first quarter, validating the changes that we made to our sales structure just a year-ago. EMEA billings grew 17%, and APAC billings grew 22%. Now turning to billings by product portfolio on Slide 4, high-end products accounted for 36% of total product billings, our mid-range products accounted for 31%, and our entry-level products accounted for 33%. Revenue was $341 million in the quarter, up 20% year-over-year. As you can see on Slide 5, revenue performance was driven by the combination of 9% year-over-year product revenue growth, and 28% year-over-year services revenue growth. The continued shift to higher services growth reflects our ongoing success in driving higher-priced subscription bundles, metered model business, and virtual solutions. On a geographic basis, from a revenue standpoint, you can see on Slide 6 and 7 that revenue continues to be diversified globally, which remains a key strength of our business. Revenue from the Americas represented 43% of our business and grew 22% year-over-year; revenue from EMEA represented 37% of our business and grew 20% year-over-year; and revenue from APAC represented 20% of our business and grew 15% year-over-year. During the first quarter, our non-GAAP gross margin was 75%. Non-GAAP services gross margin was 84%. Non-GAAP product gross margin was 60%. We continue to focus on productivity and efficiency in our operating model, paying close attention to the growth in billings versus operating expenses. On a year-over-year basis in the first quarter, billings grew by 22%, while sales and marketing expense grew just - by just 16%. As expected, general and administrative expenses were elevated in the first quarter due in part to preparations for our implementation of the new revenue accounting standard. In all, year-over-year we had $73 million of incremental billings, on just $31 million in incremental operating expense. As a percentage of revenue on a non-GAAP basis, sales and marketing expenses were 44%, down from 46% in the first quarter of last year, research and development expenses were 13% flat from last year, and general and administrative expenses were 5% also flat with last year. Total non-GAAP operating expenses were $211 million during the first quarter, resulting in non-GAAP operating income of $43 million, or 13% of total revenue, up 200 basis points year-over-year. Non-GAAP net income for the first quarter was $31 million or $0.17 per share, based on approximately 178 million diluted shares outstanding. As expected, the annualized non-GAAP tax rate declined to 32%. As seen on Slide 8 and 9, we ended the first quarter with a strong balance sheet, including $1,444 million in cash and investments. Free cash flow in the quarter was $116 million, an increase of 65% over the first quarter of 2016. Annualized inventory turns for Q1 were 1.6. Inventory turns were lower than expected in the first quarter due to early receipt of $8 million of inventory that was scheduled for Q2 delivery, and due to a ramp in inventory for our transition from the D to E series of appliances. We expect to normalize our inventory turns to 2 or better over the next several quarters. Deferred revenue increased to $1.098 billion, an increase of $261 million or 31% year-over-year. DSO was 71 days. Before I discuss guidance for the second quarter, I want to provide an update on our real estate plans. As I mentioned on our fourth quarter call, we are addressing our facilities requirements over the next several years both at headquarters in California as well as in Vancouver. At the beginning of the year, we guided $140 million to 150 million in CapEx for 2017, including approximately $120 million on real estate. Earlier this month, we concluded the purchase of the Vancouver building, so the vast majority of the real estate CapEx for 2017 will occur in the second quarter, affecting our Q2 free cash flow. We expect to return to strong free cash flow generation in the second half of the year. Let me now finish with our guidance for the second quarter, and updates to our previously issued guidance for the full-year, which can be seen on Slide 10. I will also address our plans for longer-term operating margin expansion. As a reminder, all forward-looking statements, including all of the guidance statements provided, are subject to Kelly's cautions 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, increasing profitability, and shareholder value creation. As I have mentioned, our model is shifting toward more margin-rich services revenue, which tends to have a higher ratio of deferral. These factors along with typical seasonality of the business and our expense structure are carefully factored into our near-term outlook. For the second quarter of 2017, we expect billings in the range of $425 million to $432 million, revenue in the range of $357 million to $363 million, non-GAAP gross margin of 74% to 75%, non-GAAP operating margin of 14% to 15%, and non-GAAP earnings per share of $0.19 to $0.20. We are updating our guidance for the full-year 2017 to reflect the first quarter's performance. For 2017, we now expect billings in the range of $1.770 billion to $1.792 billion, revenue in the range of $1.485 billion to $1.495 billion, non-GAAP gross margin of 74% to 75%, and non-GAAP earnings per share of $0.89 to $0.91. We had approximately $2 million of overachievement in non-GAAP operating income in the first quarter, which equates to approximately 10 to 20 basis points of operating margin on the full-year at the middle of the range. We are adding that to our non-GAAP operating margin expectation for the year. I'd like to conclude with some commentary on our longer-term operating model. As you know, over the last couple of years Fortinet has carefully considered our investment strategy to find an appropriate balance between high revenue growth and profitability. We made critical investments in sales and marketing to broaden our go to market capabilities, and focused on driving higher margin recurring revenue streams. In 2016, these efforts delivered non-GAAP operating margin improvements of approximately 200 basis points, exceeding our operating margin guidance despite the dilution from the acquisition of AccelOps. We remain focused on driving higher sales productivity and maintaining a flat organization. We also have made a number of model and productivity improvements, and changes to our operating structure to increase profitability. As our Q1 results illustrate, we are seeing the benefits of our focus, efforts and strategy. We meet with shareholders frequently, and have heard from many of you that you would like more clarity and definition related to our path to operating margin improvement. In response to this feedback, and recognizing the importance of increased profitability to our business and our shareholders, we are updating our margin targets as well as the milestones we expect to achieve to get there. We plan to add 150 to 200 basis points to operating margins each year following 2017, reaching a minimum non-GAAP operating margin of 25% by 2022, and remaining thereafter in the 25% to 30% range. We appreciate our shareholders' feedback, and we welcome an ongoing dialogue with you on how to improve our business and increase shareholder value. Now, I'll hand the call back to Ken to close.

Thank you, Drew. We are very pleased with our first quarter results and with the progress that Fortinet is making. The Fortinet Security Fabric is winning in the marketplace and we are gaining market share against our competitors. We believe the long-term operating model that Drew just outlined will bring the best value to our shareholders. Our first quarter results illustrate that our strategy to expand operating margin is working. And we believe our model will continue to offer improved profitability and value to our shareholders, while allowing Fortinet to remain an industry leader. In closing, I would like to thank Fortinet employees, partners, customers, and shareholders for their continued confidence and support.

Operator, you may now start the Q&A.

[Operator Instructions] And our first question comes from Gabriela Borges with Goldman Sachs. Your line is now open.

Great. Good afternoon. Thanks for taking in the question. Congrats on the solid results. Maybe I'll pick up right where the prepared remarks left off on the new operating model. Drew, Ken, maybe you could just comment on how you arrived at that 25%-plus target in the 2022 timeframe, and how you think about what the right level of revenue growth will be as you progress from where you are now today to that 25% level. Thank you.

Sure, Gabriela. Yes, I think we're - first of all, historically, I think a while back we were in the mid-20s. We felt like we could get back there. And if we look around the industry, we thought that was closer to a longer but term [ph] benchmark that made sense for us. We know where we made the investments. I think we've been saying all along that we like the flat model and the changes that we made over the last year and they appear to be working. And so, I think now the kind of stage two of that is really the path into driving higher productivity and operating margins over the next years. As far as revenue growth, I mean, without getting into that, we continue to want to take share. We believe our model supports doing that. Historically, we've done that and we think we can do that while also expanding margins at the same time.

Yes, also the Security Fabric story also starting and hence the sales, I mean, for the cross-sell for the upsell opportunity. And also, we see the security at ISP or the security processor also starting as a long advantage over competitors. That all can help in keeping expanding the margin, also help increase the growth.

Great. I appreciate the color. Thank you.

Our next question comes from Melissa Gorham with Morgan Stanley. Your line is now open.

Great. Thank you for taking my question. I would want to maybe start with the deal that you mentioned at the beginning, Drew. I think it was a $12 million deal. And I'm wondering if you can maybe just provide a little bit more color as it seems pretty significant for you all. Is there anything that you can talk about in terms of whether it was a competitive displacement? And is it fair to assume that that was a multi-year deal and was that embedded in your expectations coming into Q1?

Well, it was a competitive win. And the customer was really looking for a long-term model in their next generation architecture over the next, say, five to ten years. And it was competitive displacement. The Fabric were the key - the Fabric and performance were the keys to winning it. And, yes, it was a longer - it was a multi-year deal. I mean, what else did you ask, I'm sorry?

Was this embedded in your expectations when you're guiding Q1, this deal?

We take variety of factors into account for the forecast, to the extent that's in the funnel, that it's weighted into the forecast decision.

Okay. Got it. And then, just one quick one on the operating margin guide. So for FY 2017 you're still looking for about 100 basis points year-over-year improvement. But it seems like the longer-term guide is looking for a little bit more of an improvement after FY 2017. So I'm just wondering why the modest operating margin improvement in FY 2017, is that just conservatism or is there some other factor to take into consideration?

Well, actually we picked up a little bit this quarter. I think we left in the table 16% for rounding. But we picked up about $2 million that we're going to get back. That will go back into the margin improvement for the year. I think it's just 10 to 20 basis points. I think we had a paragraph on that in the script if you will. And so, we wanted to give the overall performance back. The other thing, weighting, if you add that to the $10 million for the revenue implementation, I think you get fairly close to 200 basis points for the year.

Got it, okay. Thank you.

Yes.

Our next question comes from Sterling Auty with JP Morgan. Your line is now open.

Yes, thanks. I want to actually ask about competitive landscape. I apologize; I missed the first few minutes of the call, if you did comment. But given all the news coming out of the various vendors in the quarter, et cetera, what are you seeing in terms of the competitive landscape? Anybody getting weaker, anybody getting stronger, any changes in who you're seeing in that kind of final shortlist in deals?

Sterling, this is Ken. I think in the big environment, we don't see much change compared with the last two years. And certain vertical space like some bigger provider carrier, they probably spend more time to planning. Some agencies [ph] where they transition to some cloud, some other service offering model; other part, where the enterprise SMB with UC is pretty strong. And also, the new product we offer in the e-models, starting to ramp up pretty quickly, also helping. On the competitor side, I don't see much changed. We're starting promoting. We call the Security Fabric. We have a pretty broad, probably broader than other competitor on the product portfolio here. Not just network security, but also the other part like for endpoint with the access part, with the application like web and e-mail security, and then to the cloud. So we have quite a broad offering, so the Fabric start really help and compete better compared to other competitors. So other than that, I see the whole environment pretty normal.

Yes, Sterling, it's Drew. I would just summarize that. And that I think the consolidation theme remains profound out there. And the Fabric is clearly resonating. And the larger deals we do, it's common theme. And I think that's very consistent with what we saw in Q4 and consistent with what we'd see going forward.

Yes, I think some - and some like - we also improve in the sales productivity like by two points compared to one year ago. It's 46% or 44%.

I think [indiscernible] has a percent on.

A percent [indiscernible].

Yes, but productivity, I don't - yes, productivity was good. Yes.

And then just one follow-up, how would you answer - the one question that I get on a frequent basis is, okay, as we look at the shift to the cloud, moving to these virtual environments, Fortinet is long been known for having your custom ASIC and gives you performance advantages, et cetera. How does Fortinet then compete in the world of AWS and Azure and public cloud providers in that situation?

Like in my script we mentioned about, we offered the best cloud and also together with the on-premise solution. So the cloud starting, generate a lot of interest. They grow faster but on pretty small base right now. On the other side, customer also evaluate - it can give them some flexibility, but don't have to - I mean, saving the cost or maybe even increase the certain risk, because you have actual data in the cloud and also have to increase the bandwidth for accessing the cloud. So there is always a sort of balance point and whether using see some cloud also using some on-premise, that's where the hybrid solution probably will be the best. So customer can like changing their like a balance point based on their need at certain point. So I think cloud have to offer certainly flexibility, but there is other part need to be considered. So that I believe the vendor side, they need to offer both. And if only one part of it, it's more difficult to meet customer demand.

Got it. Thank you.

Yes. And it's also - right now, it's helping pull through on-premise for us as well, Sterling.

Yes, also the new security processor also being used by lot of cloud provider, service provider, because they can drive much better performance and efficiency policy when compared with the traditional CPU. They can easily improve the performance like 10 to 100 axiom [ph], then consume like a few percent of the power consumption. So there is a lot of advantage. And also in the SMB in the - at our branch office to access the cloud that's where the low-end we see pretty healthy growth also.

That makes sense.

Our next question comes from Mike Casado with Pacific Crest. Your line is now open.

Great. Sorry to disappoint, this is actually Rob Owens in for Mike Casado. So hi, guys. A couple of things - dovetailing Sterling's question a little bit, so thanks for the color on the competitive landscape. Can you also talk about where you think we are in terms of the firewall cycle? Are there still firewall cycles, is there any anticipated refresh. We are starting to pick up through some of our channel work that people are looking optimistically at next year. So just some broader color in terms of where you think we are in terms of an overall industry refresh cycle first? Thanks.

I think that refresh cycle, probably, we see the buying pattern in like two years ago kind of - we call the rush buying. Now, newly the network security equipment probably will survive for four, five years. And then they start gliding [ph] the cycle there. I think a few are like under one, two, three year to go. But also the service providers, under like a lot of us being branch office, we also see pretty strong demand, and also because the cybersecurity is always the most important part of IT, the total percentage also keep increasing. So we do see the overall market growing pretty healthy. And a lot of existing customers, they also want to expand beyond just the traditional firewall. That's where the Fabric, the Security Fabric stories starting working much better than just to refresh the firewall. So basically you can cover from endpoint, to the access, to the networking side with traditional firewall doing, and also the application, and then the cloud. So that's where tie all this together has a much better solution feature compared to refreshing. So we see all these studying kind of helping the growth.

Rob, we were talking about this earlier today actually. And we always thought that target, if you go back - I think it was late 2013. That was really the kick off for the last big I think spike if you will in the spending. And then it went on for couple of years, obviously. And that, when you get into 2018 that's four years roughly from, say, that happened and then understanding [ph] it started to happen in 2014, early 2014. I think probably somewhere in 2018, you would begin to see that click in the [four to fifteen] [ph] I think the consolidation theme probably does create an opportunity from the Fabric perspective for us. And that's really how we are thinking about this opportunity.

Great. I appreciate the color. And then second, if I look at your sequential services revenues, I guess, going back historically it was flat up or down a couple of percent. But last year you saw a spike sequentially from Q4 to Q1 in services. So maybe talk about why this is more normal seasonality and remind us what happened in that year-ago period Q1 2016 that drove that services spike? And I apologize, if this was referenced earlier, I was late to the call. Thanks.

The services spike - I actually think that the answer this year is probably more due to Q3 this year. We had a softer Q3. And so, you don't see as much of the registrations come through in Q1, when you would expect the revenue to lift up, start amortizing.

Thank you.

Also, we starting offer the, what we call the enterprise bundle, which has more service component, but one year ago. That also started helping to see the service percentage get higher now.

Our next question comes from Walter Pritchard with Citi. Your line is now open.

Hi, thanks. Ken, could you talk about the non-FortiGate business, the size of that and how you are thinking about that kind of medium-term in terms of how large that may be come as a percentage of your revenue?

The non-FortiGate side grew faster than FortiGate. And also feed in the total solution covered a whole infrastructure is that just some network side looks much better. I don't think we disclose the detail percentage yet, but it's starting to get - definitely grow faster than the FortiGate. Drew, any data we can…?

Yes, Walter, I mean, I don't think we are giving numbers out, but I - generally speaking that's been the story for the last couple of quarters. Where we've seen a nice uptick on the Fabric, and then illustrated the non-FortiGate project - products that's doing well. We also look at the number of Fabric customers if you will. And that's been growing very nicely and nice trend there which adds to it. And then finally, the enterprise bundle again it was a very strong story in Q1, and very consistent with last several quarters. So we are seeing a lot of consistency in kind of the themes internally around productivity seem to be lifting and part of it doing just do selling multi-product deals, selling non-FortiGate products, up selling the bundle, the enterprise bundle, and so very good on that front.

Andrew, just a follow-up here, is it fair to say that if that business were more than 10% your revenue, you would break it out was non-FortiGate?

Yes, we haven't decided on that one, Walter.

Okay. Thank you.

Our next question comes from Jayson Nolan with Baird. Your line is now open.

Okay, great. Thank you. And Drew, I wanted to follow-up on the updated operating model it seems like sales and marketing were offer the most long-term leverage, and I guess on the question is what's the change now versus the previous guidance. Is the expectation for your headcounts ads going forward, and sales are changing. And how you market the products or any more color there would be great?

Well, a couple of things like I did think you want to start with the top line, Jayson. So we are doing - the strategy around creating the higher margin, higher price recurring revenue streams. That's obviously coming through, you could see in the billings, and you could see in the deferred revenue. We expect that drive value to the gross margin line over time. And then as you move down in to sales and marketing, that's where the bulk of our investments, or if we go back historically that's where we want to see the productivity. And the way, you get there is some of the things you were taking about, Jayson, but really what to trying to do is give them opportunity to sell more at higher price, and so I think we are doing well on that firm, we just talked about the non-FortiGate sales and the Fabric sales. So that's one dimension of that. Then the other thing, we didn't, if you look at the pivot we made in August to really go to, what I would call a flatter very customer centric sales model. That part is working very well. And from customer centric, I mean, we are very focused direct touch reps versus overlays, and very direct SE coverage, more direct contact with the customer. We still have - we are still very focused on the channel, but we have just more direct customer touch. And that was the focus really scaling up the augment functions over time, and that's where you would have less headcount over time on those functions. We also think the marketing the go-to-market and to the marketing is working, training helps, you got higher productivity through training. We made investments there those are beginning to scale, and show fruit in terms of the Fabric sales and just the higher productivity overall. So that's really the story there, when you look down the line on R&D and G&A, you probably expect to go a little more out of G&A over time then R&D, certainly the revenue project goes away at some point for instance. And we should see those benefits over time.

Yes, also there are some change in the whole environment, I think you can see in the last few years some competitor were aggressively to the marketing sales, it's very difficult to sustain the long-term. And if you - right now, the whole inventory [ph] study more look in how to be a little bit more efficient healthy model and sustain long-term, as also like we also believe this long-term model probably can would be better for the shareholder and for the company also.

Ken, make sense. And then follow-up, like Ken, on ASIC refresh calendar, any color you can provide on refresh around the network processor, it seems like it would be important for the high-end of your customer base?

Yes, we have a three security processor like pretty much every year there is one new come up, because on average it takes about three year to build the security processor. So the CP9 we just mentioned like come up study helping the high end especially to 7000 series, and there is also IOC, and that's in the network processor. I think, they are not directly impact revenue, because they still needed some to build into the product, and then we refresh products like few products every quarter pretty smoothly, steady, helping the growth. But you can see the latest offer we made on a 7000 series that leverage latest security processor CP9 can help the performance grows a lot. And then we probably see the other next generation like IOC that also can easily improve the performance multiple times. That's also what keep the cost the same. That's also helping the growth a lot. But I say, while keeping probably on average one new offering or regression [ph] per year on the security process side.

Thank you.

Our next question comes from Ken Talanian with Evercore. Your line is now open.

Hi, guys. Thanks for taking the question. So first, I was wondering if you could discuss any changes that you've made either your hiring processes, your systems, to better manage your OpEx?

Well, Ken, we are very focused on making sure that we look at every open headcount rack and every - the background - everyone coming in the door. And that's part of the flat structure that we are talking about were Ken and myself, and Lisa, our VP of HR are all focused on looking at every rack and every person comes in the door and there background makes sure it's fit. We also evaluate where we are, and I think the key here is you want to bring people in, you want to make sure that they are going into place, we feel there fertility and opportunity for them to be productive both near and long-term. And so that's we are really trying to do. And then balance, the purchase investments we have over time in to their roles. And last thing I would add is, when you think about the ramp of this. You want to do it in the way that doesn't create disruption, because clearly if you go too fast, it just becomes disruptive. And that's how we think about, but we really want to keep a flat organization very much, and we've been saying this for several quarters now later focused on productivity, and that is the primary driver.

And also the mid-20 operation margin, we have achieved that in 2012. So we have reached a level before, and then just in the last few years, we kind of more invention of growth. Now kind of more go back to the normal and take care both the profit and the growth side.

Okay. And I just curious, if the economy were return negative over the next few years, or the security market were return. Would you be willing to forego top line growth to hit those margin targets?

I think, in the industry for like 20 plus years. Sometime even when economy goes slow, we are not impact security that much, because if you want to keep the security. And also security is pretty sticky and is it difficult to replace, the cost could be higher.

Ken, I think the - look the answer is, you obviously want to step back and look at what's going on in the industry. But we are very focused and committed to driving the higher margins. I mean that's the model we are operating under, and again we are trying to ramp there in a productive way, if you will. We feel like, we've done a very good job of building the model, we wanted to do over the last couple of years in terms of our go to market adjustments that we've made, you will find those and then you are very focused on the higher margin recurring revenue streams, which are also coming in. so that that's what we are going.

Okay. Thank you very much.

And I want to say, we've got about 10 more people lined up for questions. So if I may have to try to restrict people to single questions going forward. And then we can follow-up again on the second call, please.

Our next question comes from Michael Turitz with Raymond James. Your line is now open.

Hey, good evening to Drew, and Ken, and Kelly. So very good to see the milestones on the margin, and the guide to 150 to 200 bps after 2017. But let me take it from this margin question with slightly different perspective, which is - why in theory couldn't we get to 20% plus margins even sooner? And when you were at mid-20s margins, when you are much smaller company growing with less scale and growing over 20%. So what's different about now, what's change that you actually have to invest in a higher rate, you couldn't get there even sooner in that.

Well, Michael, I think, you want to balance productivity, again disruption the impacts in the risks of disruption. We've done a very good job of rebuilding the model we believe, we pivoted to the enterprise, and that's doing very well. And you want to continue to drive those higher margins. And we are going to look at everything we can to achieve our results are better. But I think you have to be very careful to avoid disruption and I think some people seeing that recently, some others have seen that. And so I think that's part of the issue, because that's going to be very damaging both short and long term.

Okay, thanks.

You're welcome.

Our next question comes from Andrew Nowinski with Piper Jaffray. Your line is now open.

All right. Thanks for taking the question. So your product revenues remain well above your peers, even today Check Point called out strength in the small and mid-market, yet they only had 2.9% growth in product revenue this quarter, and obviously Palo Alto seeing some product revenue to decline? So can you just give us any color on us to what drove of the strength in your product revenue this quarter, and then kind of what you are expecting that to stay at through FY 2017 for based on your new guidance?

Yes, I think some of the new product like whether the e-model and also some high-end product offer to the big enterprise service provider is to help drive the growth. And also we have a quite big installation base, I think based on IDC probably like more than 25% total global installed deploy [ph] base is a Fortinet ForitGate solution there. So that's also having - keep in driving and we also keeping refresh the product, which like - said earlier like every few years, customer also need to refresh product to get a better performance more function that also helping to drive with product growth. And then the service also, because the new products offer additional function, additional service that's also kind of helping to drive the long-term service growth.

Got it. And then what level you're expecting for the remainder of 2017, and keeping in this high-single-digit?

Yes. We don't - unfortunately we don't guide on product revenue, Andrew. There is the one thing I would mention is there, we try to - I think we were try to be helpful with the mix shift in Q3, and it was about - we thought about 200 to 300 basis points of product revenue is now reflected on the services line, if you think of it, it's being more software that's ratable, more metered model those appear on the services line. And then also with the enterprise bundle, you end up re-attributing through accounting more of the product up from the invoice on to the services deferred revenue and then amortizing over time. So do you measure that that's probably close to 500 bps that's really now that year-ago probably going to showing up on the product line, it's now showing up on the services line.

Got it. Thank you.

So big number, yes.

Our next question comes from [indiscernible] with Barclays. Your line is now open.

Hi, guys. Thanks for taking my question here. Drew, I've got a philosophical question for you, maybe slightly different way of asking Mike Turitz' question earlier. But what factors went into updating the long-term model. We certainly appreciate the path and the milestone. But we're just - I was just wondering, is it something that - is it part of sort of a normal five-year planning type of process or what went to kind of thinking about profitability even beyond the original fiscal 20 target?

Philosophically, we were just - I think it's the next stage of the company. If you go back a few years, we took down the margins really, because we wanted to build out an enterprise sales force and a broader go-to-market model so to speak, broader go-to-market model. That took some investment. And we refined it along the way. And we feel now as we've gone through a couple of quarters here, a year past, I think reorganizing if you will the sales force in the U.S. And we feel like we're doing very well. There is also - and we felt like the maturation of the model would then provide the benefits that we were hoping for all along. And we look at that obviously. We model it. We look at the vectors of that. Clearly, the mix shift on the gross margin line is helpful. Looking at productivity and you look at the natural ramp for it over time. Also, I mean, we received a lot of shareholder feedback to be frank. And we want to make sure that, one, we show we appreciate our shareholders' feedback. And we continually focus on creating - increasing shareholder value. So we appreciate everybody's feedback, that's very helpful.

Fair enough. Thanks very much, Drew.

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

Thank you. Good afternoon, guys. Congrats on the solid set of results. Drew, solid performance in the Americas. I know you guys don't break out the U.S. contribution within the slides. But can you provide us with some qualitative description of Fortinet's progress in the U.S. during the quarter, whatever color you can share with us? Thank you.

Yeah, the billings growth from the U.S. was very good. It was about 31%. And so, again, that's where we made a lot of the investments and whether you - when you look at that kind of near-term and longer-term that's - you get very comfortable that we start to get very comfortable with the productivity and improvements in the things we talked about in the rebuilding the go-to-market model and the refinements we made over time. It feels like the numbers indicate that that is going in the right direction.

Got it. Thank you.

Our next question comes from Catharine Trebnick with Dougherty. Your line is now open.

Thank you. Congratulations on the quarter. Mine is more on the service provider venue. It seems like a lot is the next generation implementations in their core networks will be NSE, SDN like. And what should the architecture that Fortinet has that would be most apt to go after that type of opportunity?

That were both on the new 7000 series, also with the new release, FortiOS 5.6, offer a lot out as a function, or lastly the SDN and Network Functions Virtualization. That's where we get a lot of our feedback from the service provider, from the cloud provider, the customer which we integrate into the - both the new hardware and also the new software.

And then, Catharine, we constantly engage with our cloud and carrier team. And ask them what to expect. And they continually tell us that we're in all of the top careers. We're working with them on their architectures. And the breadth of portfolio, the Fabric matters and obviously, historically, performance matters. But we can help them, whether it's virtual or physical. And the other factor that we tend to see is just that whatever - they want to run their businesses inside out, so what they're sharing - what they're using or providing to their customers, they also want to run their systems on and run their business. And we feel like we're in those top prospects, they're forthcoming.

Okay. Thanks, and I'll save some more up for the next call. Thank you, gentlemen.

Thanks, Catharine.

Our next question comes from Erik Suppiger with JMP Securities. Your line is now open.

Hey, guys. Thanks for taking my question. This is John on for Erik. I was just looking at your headcount additions. It looked like you added 50 headcount per quarter over the last three quarters. It looks like the lowest level since 2011. So firstly, is this intentional or would you like to be adding more headcount in that. And then secondly, is increased attrition weighing on your headcount growth or has attrition remained constant over the last year?

Erik, we evaluate the headcount based on the value they bring back to us. So again, we're doing a couple of things. We're trying to make sure we're covering the right opportunities, both from a customer perspective and then also from an R&D perspective and then the various other things we need to do to grow and scale the operations. But we're very focused on looking at the headcount requisitions that we open and they tie to that model, that they bring back an appropriate incremental return so that, one, that it makes sense term, but also long-term. Then, Ken, myself and as I said, Lisa, VP of HR, look at every hire that comes in the door from a resume perspective and what they're doing. And I think we just become increasingly focused on - we said several quarters ago. We're laser focused on productivity. And we continue to do that and we feel like that mode of operation. That process is working very well.

So should we expect 50 going forward, 50 headcount additions going forward this quarter?

Well, we really been guiding on operating margin, Erik.

Okay. Thank you.

Our next question comes from Patrick Colville with Arete Research. Your line is now open.

Thanks for taking the question. So the guidance implies for billings and revenue pretty steep sequential deceleration. Can you just help me understand what I might be missing? So that kind of manifests itself, because momentum is really strong.

A couple of things, Patrick, one, clearly if you think about our business and now it's changed over time, first of all our SMB channel business is fine. It's very consistent and it's been doing very well. We've gone more into the enterprise. And what happens then is you now have inherently a more - I hate to use this word, but lumpiness to the business. And it just tends to be more pushed towards the end of the quarter. And so we're trying to do our best to adjust for any of that in terms of timing and take that all into account. And any given quarter you can get one or two large deals that can dramatically influence the results. And for instance, this quarter we had the university, the deal that we spoke about earlier, the $12 million - they'll be slightly north of $12 million. And so that can happen. We're just trying to take all those things into account when we look at it.

Okay. Great. Thanks. Nice work.

Yes.

Our next question comes from Fatima Boolani with UBS. Your line is now open.

Hi, thank you for taking the question. Drew, just wanted to double click on the comments you made around productivity. It's very evident in the results that the changes you've made and the investments you've made have been paying off. But I'm curious if you can maybe qualitatively talk about sales force tenure and attrition levels, especially as we've now anniversaried Patricia's changes in North America. So any qualitative color around that would be very helpful. Thank you.

Yes, I think we've done a - Fatima, it feels like we've done a great job of hiring the right people to approach the enterprise. And so, that's worked well. We don't - typically, aren't going to share exact tenure statistics, but I would say that statistic has improved since Q3 I think when we did share some. So we feel like we're better positioned and we're seeing that more consistent performance over time. And I really think that's the key driver, just getting people in the C getting them trained and the consistent performance.

Yes, also the marketing side also has and starting helping contribute in the result. And then also we offer probably the best training and the biggest training program in the industry. That's where both on the customer and the partner. And also even our own sales force side also was starting benefit from other - the training program we did.

Very helpful. Thank you.

And we have time for one more question. It comes from the line of Tal Liani from Bank of America. Your line is now open.

Hi, guys. Thanks for taking my question. This is Mike on behalf of Tal. So billings growth rate was solid this quarter, up 22%. But your guidance is calling for deceleration to about 15% in the second quarter. Can you give us little color on any other areas in your - or what are the areas in your pipeline are contributing to some of that deceleration? Thanks.

Hi, Mike. Fatima asked a similar question just a minute ago. So let me repeat what I said and then maybe add a little bit on to that. There are various elements or parts of our business, if you will, dimensions. And so think of this SMB as being a fairly consistent flow of business, and so, that one tends to be a little easier to predict if you will. We've been more focused on the enterprise. We've been very successful there. We're seeing the uptick in larger deals. What goes along with that though is it tends to be more of the deals falling into quarter end, closer to quarter, as enterprises are very good at pushing you to that to get the best deal. And so that timing, the lumpiness and timing that goes along with that are really addressed in how we guide. We're thinking about that very closely as we guide. What I would say, there was a larger deal that we mentioned during the quarter and I think if you adjust for that a little bit and you come off of - you'll come into a more what I would probably consider a historical sequential range for us from Q1 into Q2. And hopefully, that's helpful, Mike.

Thanks.

Yeah.

I would now like to turn the call back over to Ms. Kelly Blough for closing remarks.

Thank you, everyone. I'm sorry we couldn't get to a couple of questions. Please do call in again at 3:30 for our next phone call. Thank you. We'll talk to you then.