Fortinet, Inc. (FTNT) Q4 2017 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Fortinet Fourth Quarter 2017 Earnings Announcement. [Operator Instructions] As a reminder, today's program is being recorded. I would now like to introduce your host for today's program, Peter Salkowski, Vice President of Investor Relations. Please go ahead.

Thank you, Jonathan. Good afternoon, everyone. This is Peter Salkowski, Vice President of Investor Relations at Fortinet, and I am pleased to welcome you to our call to discuss Fortinet's financial results for the fourth quarter and full-year 2017. Speakers on today's call are Ken Xie, Fortinet's Founder, Chairman and CEO; Drew Del Matto, CFO; and Keith Jensen, CAO. This is a live call and will be available for replay via webcast on our Investor Relations website. Ken will begin our call today by providing a high-level perspective on our business. Drew will then follow with our financial and operating results, and Keith will conclude with providing our forward guidance outlook before opening up the call for questions. [Operator Instructions] As a reminder, today, we're holding two calls. For those who have additional questions, we will hold a second conference call at 3:30 p.m. 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 and our most recent Form 10-K and Form 10-Q for more information. All forward-looking statements reflect our opinions only as of the date of this presentation, and we undertake no obligation and specifically disclaim any obligation to update forward-looking statements. Also, I'd like to remind everyone that all references to financial metrics that we make on today's call are non-GAAP, unless otherwise stated. Our GAAP results and GAAP to non-GAAP reconciliations can be found in our earnings press release and on Slides 13 through 16 of the presentation that accompanies today's remarks. We also encourage you to refer to our Investor Relations section of our website 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 be available on our website. I will now turn the call over to Ken.

Thanks to everyone for joining today's call to discuss our fourth quarter and full year 2017 result. As we begin 2018, Fortinet has more market momentum and opportunities than ever. Our fourth quarter again demonstrated strong market leadership with revenue and billing growth of 15%. For the full year 2017, our revenue grew 17%, while our billing grew 19%. Based on reported billings, Fortinet grow faster than any of our top competitors over the last four quarters. In 2018, we will continue to deliver growth in excess of the market, balanced with profitability. Four powerful growth engines will drive our business in 2018. First, our core business of network security continues to offer growth in new, displacement and adjacent market such as SD-WAN. The announcement we did today of FortiGate 6000 series will provide another opportunity for market share gains. The 6000 series is the fastest next-generation firewall appliance in the industry and is fully integrated with the Fortinet Security Fabric. It is built upon a new hardware process and architecture that delivers over 100-gig of advanced threat protection and SSL inspection to handle massive volume of traffic driven by increased adoption of the cloud. Second, we have only just begun to scratch the surface of the Security Fabric adoption. Billings for non-FortiGate security product and services were about a quarter of our business. We are still in the early stage of Security Fabric adoption, and there's a huge opportunity for growth. Third, cloud security is the fastest-growing part of our business. We will continue to expand our solution and the business model for multi-cloud environments. We deliver the broadest portfolio of cloud security applications, all managed through a single, integrated, management console with automated threat response and policy, unified control, workload visibility and management across all cloud environments. We just announced that Fortinet cloud security is now available on the Google Cloud Platform, making our cloud security solution available across all major cloud providers, including Microsoft, AWS, Google, IBM and Oracle. For the fourth growth engine, we will continue to extend broad security to IoT and OT environments. In January, at CES, we demonstrated integrated security and threat protection for the connected car for the future, an example of how IoT and digital transformation are creating new security growth opportunities. In 2017, we received more independent industry validation than our close competitor, with eight recommendations from NSS Labs. And as of 2017, Fortinet now appears in six Gartner Magic Quadrant. Fortinet is strongly positioned to lead in each of these area because of our vision, investment, and superior technology. Fortinet also continue to expand the visibility and control of Security Fabric to third-party solution providers. In 2017 alone, we welcomed 18 new partners to our Fabric-Ready Partner Program, including industry leaders such as Intel, AWS, Microsoft. Our Fabric-Ready Program now stretches to 37 eco partners. Our reach in the market continue to expand. The investment we have made in sales and marketing has driven strong penetration in the enterprise space, which was a key driver to our growth in 2017. According to IDC, we again shipped more appliance than our two nearest competitors combined through Q3 of 2017. This unit-driven increase to subscription services and other security functionality and enable us to monetize our customer base for the years to come. I and the rest of the leadership team and Fortinet are proud of the significant accomplishments our team made in 2017, and we look forward to even greater success in 2018 and beyond. Before I turn the call over to Drew to review our fourth quarter and the full-year results, I would like to share that this afternoon we announced the appointment of Keith Jensen as our Interim Chief Finance Officer, effective February 16. Keith will be replacing Drew who has served as the CFO since January 2014 and is departing Fortinet for another opportunity. Drew has made a strong impact on the business and has significantly contributed to the company's growth and profitability. During his time here, he developed a deep bench of seasoned leaders and a strong financial organization to support and grow the business. We wish Drew the very best in his new role, and we thank him for his significant contributions. I will now turn the call over to Drew.

Thank you, Ken. My past four years at Fortinet have been incredibly rewarding, and I'm honored to have worked with Ken, Michael and the rest of the Fortinet team. I'll miss everyone as I move onto a new opportunity, and I'm excited for Keith to be taking over the Interim CFO role. Given today's announcement, I'm going to review our fourth quarter results and then hand the call over to Keith so he can provide guidance. Let me now share our financial results for the fourth quarter, which can be seen on Slide 3. Fortinet had a very strong end to 2017. For Q4 2017, billings increased 15% year-over-year to $534 million. Revenue of $417 million was also up 15% year-over-year. Security subscriptions and support services continued to drive our business with overall services revenue growing 25% year-over-year. Deferred revenue grew to $1.336 billion up 29% year-over-year, reflecting the ongoing business shift to more margin-rich recurring security subscriptions and support services. Our non-GAAP gross margin was 76%. Non-GAAP operating margin was 19%, and non-GAAP earnings per share were $0.32. We generated free cash flow of $144 million or 35% of revenue. Operating cash flow was $158 million, an increase of 56% year-over-year. For FY 2017, billings grew 19% to $1.796 billion. Revenue grew 17% to $1.495 billion. Our non-GAAP operating margin for 2017 was 17.2%, which grew 210 basis points over 2016. In 2017, the business generated $459 million in free cash flow and used $446 million to repurchase 11.2 million shares of Fortinet stock. This quarter, we experienced strong deal flow in our six-figure enterprise deals, driven by the adoption of Fortinet Security Fabric. Non-FortiGate-related billings represented about a quarter of our billings in the fourth quarter and for the full year. Multiple product adoption continues to contribute to growth in deal sizes. Year-over-year, the number of deals over $100,000 grew 21%. The number of deals over $250,000 grew 31%, while deals over $500,000 grew 24%. We had a record 40 deals over $1 million in the quarter, beating the previous record of 39 deals recorded in the fourth quarter of 2016. Among our enterprise successes in the quarter was a mid-seven-figure deal with a U.S. CRM company. This new Fortinet customer sought a single vendor that could unify and integrate security across the next-generation network infrastructure, stretching from the local area network to the cloud. We provided a truly integrated and comprehensive fabric solution, including FortiGate, FortiAnalyzer, FortiManager, FortiSIEM and FortiSandbox. This customer is a good example of a hybrid cloud implementation of Fortinet Security Fabric using Fortinet's AWS offering managed centrally from their security operations center and seamlessly integrated with their on-premise security deployment. The breakdown of billings across our top 5 verticals was service provider at 22%, government at 16%, financial services at 12%, retail at 9% and education at 8%. The cloud continues to be a driver for our business. In 2017, billings driven by the cloud, including virtual machines, SaaS, and hyperscalers represented the fastest-growing part of our business. We also saw strong growth in on-demand consumption. Across all cloud partners, we are seeing strong growth with five and six-figure engagements through AWS and Azure. As Ken mentioned, we're very excited that Fortinet cloud security is now available on the Google Cloud Platform. Our government business in the United States and the rest of the world continues to expand, demonstrating that customers with the highest level of security needs trust Fortinet to protect their most sensitive data and assets. For example, during the fourth quarter, a European government agency that handles highly confidential information chose Fortinet over an incumbent solution in a large fabric contract. This customer chose Fortinet Security Fabric for its high level of performance, as well as our industry-leading integration, segmentation and threat intelligence capabilities. Turning to billings by product range on Slide 4. High-end product billings accounted for 41% of total product billings; midrange products accounted for 29%; and our entry-level products accounted for 30%. It's important to note that deals, including high and midrange products tend to include more security subscriptions, support services and more non-fabric solutions. Revenue in the fourth quarter was $417 million, up 15% over a very strong fourth quarter of 2016. As you can see on Slide 5, revenue performance was driven by 25% year-over-year services revenue growth. Product revenue was up 2% year-over-year. As previously mentioned, there are two significant reasons for the single digit product revenue growth. First, the mix shift towards higher-value security subscriptions and support services leads to a larger percentage of revenue being deferred onto the balance sheet for recognition in future periods. Second, our continued enterprise segment success is leading to longer-term deals. As a result, our average contract length in the fourth quarter increased sequentially one month to 26 months. As you could see from Slide 6 and 7, revenue from the Americas represented 42% of our business and grew 16% year-over-year. Revenue from EMEA represented 38% of our business and grew 14% year-over-year. And revenue from APAC represented 20% of our business and also grew 14% year-over-year. On a geographic basis, billings in the Americas grew 10% year-over-year. EMEA billings grew 20%, and APAC billings grew 17%. Our gross margin remains strong due to the mix shift in our business driving high-margin subscriptions and deferred revenue. This deferred revenue will roll off the balance sheet into revenue in subsequent period, providing a tailwind to longer-term gross margins. During the fourth quarter, our non-GAAP gross margin was 76%. Non-GAAP services gross margin was 87%. Non-GAAP product gross margin was 58%. As I've mentioned in prior quarters, this also negatively affects our product gross margin as hardware costs are recognized in the income statement upon shipment. Additionally, when this deferred revenue rolls off the balance sheet into the revenue, it's recognized without any associated COGS. Non-GAAP operating expenses were $237 million during the fourth quarter, resulting in non-GAAP operating income of $79 million or 19% of revenue. Non-GAAP net income for the fourth quarter was $55 million or $0.32 per share based on approximately 175 million diluted shares, a reduction of 3.6 million shares from the third quarter, due to share repurchases. As expected, the annualized non-GAAP tax rate was 32%. Slides 8 and 9 review our balance sheet and provide more information for your reference on our cash flow. We ended the quarter with a strong balance sheet, including $1.349 billion in cash and investments. As I mentioned earlier, cash from operations was $158 million, representing growth of 56% over the same period last year. Free cash flow in the quarter was $144 million. In 2017, Fortinet generated free cash flow of $459 million. On an adjusted basis, excluding real estate purchases, Fortinet generated $566 million in 2017, representing a free cash flow margin of 38%. We've added an adjusted free cash flow slide, Number 10 in the deck, for your reference. Deferred revenue grew to $1.336 billion, an increase of $301 million or 29% year-over-year. DSO was 75 days, down 3 days from the fourth quarter of 2016. Returning value to our shareholders was a key hallmark of 2017. As promised on our prior call, we were aggressive with share repurchases in the fourth quarter. We used $322 million to repurchase a total of 7.9 million shares at an average price of $40.73. In 2017, we used $446 million to repurchase 11.2 million shares of Fortinet stock at an average price of $39.83. As of December 31, 2017, approximately $443 million remained in our Board of Directors' authorization for share repurchases through January of 2019. For the full-year 2017, billings were $1.796 billion, representing growth of 19% over 2016. Revenue grew 17% to $1.495 billion. Non-GAAP gross margin was 75% and non-GAAP operating margin was 17.2%, representing an improvement of 210 basis points over 2016. This is 120 basis points higher than what we originally guided for the year. Now, I'd like to introduce everyone to Keith Jensen who will be named Fortinet's Interim CFO upon my departure. Keith is a 35-year finance veteran who I hired in May of 2014 to be our Chief Accounting Officer. Before becoming a valuable part of my team, Keith served as the Chief Administrative and Accounting Officer at DataDirect Networks and Chief Accounting Officer at Sybase. Before Sybase, Keith was Chief Financial Officer of Dorado Network Systems. With that, I'd like to turn the call over to Keith.

Thank you, Drew. Before I go through our guidance, I'd like to thank Drew for being an excellent leader, mentor, and friend for the past four years. It was a pleasure working with you, Drew, and I wish you very well in your next endeavor. I'd now like to share our guidance for the first quarter and full-year of 2018, which can be seen on Slide 12. As a reminder, all forward-looking statements, including all of the guidance statements provided, are subject to Peter's caution at the start of this call. For the first quarter of 2018, we expect billings in the range of $449 million to $457 million, reflecting first quarter seasonality; revenue in the range of $387 million to $393 million, also impacted by seasonality; non-GAAP gross margin of 75% to 76%; non-GAAP operating margins of 12% to 13%, also impacted by seasonality and our continued investment in our sales team. Please note, we expect the operating margin benefit of at least 150 basis points from the adoption of ASC 606, taking our operating margin up to a range of 13.5% to 14.5%. I'd also note non-GAAP earnings per share for the quarter at $0.21 to $0.22. For 2018, we expect billings in the range of $2.030 billion to $2.050 billion; revenue in the range of $1.695 billion to $1.715 billion; non-GAAP gross margin of 75% to 76%; non-GAAP operating margin of 17.7% to 18%, representing a 170 to 200 basis-point improvement over our original 2017 guidance. Note also, we expect an additional operating benefit of at least 150 basis points from the adoption of ASC 606, taking our operating margins up to a range of 19.2% to 19.5%; the non-GAAP tax rate at 24%; non-GAAP earnings per share for the year, $1.30 and $1.32. Now, I'll hand the call back over to Ken to close.

Thank you, Keith, and congratulations on your promotion to Fortinet Interim Chief Finance Officer, and thank you again, Drew, for your outstanding contribution to Fortinet. We are very pleased with our strong finish to 2017 and with the industry leadership that Fortinet continue to demonstrate. I would like to thank Fortinet employee, partner, customer, and shareholders for their continued confidence and support.

Operator, before we begin the Q&A, I'd like to invite everybody on the call to the 2018 Analyst Day event taking place at The Cosmopolitan Hotel in Las Vegas on Tuesday, February 27. A registration link can be found in the Investor Relations section of our website under Events. Financial presentations will be webcast and available on our IR website, but we hope to see many of you there. With that, operator, we're ready to start the Q&A session.

Certainly. [Operator Instructions] Our first question comes from the line of Melissa Franchi from Morgan Stanley. Your question please.

Thank you for taking my question. Drew, congratulations to you and best of luck. So just a question on the Q4 billings growth. I think last quarter when you guided, you noted a number of headwinds, including, I think, elongating sales cycles as you are just moving into the enterprise space, as well as under-hiring in sales heads. So, I'm just wondering if you can maybe update us on how those factors played out in the quarter relative to your expectations. And was there anything that came in a little bit better or perhaps a little bit worse than what you were expecting?

Thank you, Melissa. I think Q4 actually went really smoothly. I mean, if you look at one of the indicators that's interesting is DSO because it was down 3 days versus Q4 of last year. And what we saw was a pretty, I would say, high-velocity quarter with transactions flowing throughout the quarter. And that's important because when we talked about some of the concerns we had when we guided, most of those turned out to not be issues at the end of the day. Things actually flowed very smoothly throughout the quarter, and it was just a nice ramp right to the end of the quarter. And when we look back, I think we only talked about Latin America and some geopolitical things and even in the carrier space, it all turned out to go really smoothly.

Okay. That’s helpful, thank you.

Thank you. Our next question comes from the line of Sterling Auty from JP Morgan. Your question please.

Thanks. I actually want to follow up on Melissa's question initially. You mentioned the one very large deal with the CRM company. It seemed like a lot of our research from a number of people on The Street were indicating there was probably more than one large deal. Were these follow-on deals? Were they large companies that were buying fabric for the first time? And was there any change in the go to market on those types of deals with any of them coming direct or through alternative channel partners than usual?

We're very committed to channel partners. We really do sell almost everything through the channel and rely on our partners to sell alongside of us. So, we're very successful on that front. The CRM deal that you referenced was a new customer. So, we won that over an incumbent. And that was truly a fabric solution. As I mentioned before, they bought not only FortiGate, but FortiAnalyzer, FortiManager, FortiSIEM, FortiSandbox and a variety of other products along the way. And it's also a hybrid cloud implementation of Fortinet Security Fabric, and they're using Amazon Web Services, AWS, which they're actually managing centrally from their own security operation center. So, it's seamlessly integrated with their on-premise security deployment and it's just a great win, illustrates the power of the fabric in an enterprise.

Got it. Got it. And you mentioned the benefit to margins from 606, but I believe in terms of the footnotes in the guidance on the slides, that the revenue does not reflect 606 impact, can you give us a sense of what that might look like?

Sure, I would try it this way. This is Keith Jensen, Sterling. We would describe the revenue impact as being insignificant both to revenue and to the trends in revenue. Small impact on some software licenses that we were previously amortizing over time, a little bit of change in the U.S. model in terms of when we recognize revenue either in sell-in or sell-through, but those are largely offset by the deferred revenue balance that we lost through with retained earnings at the adoption date. So, net-net, no impact to the revenue that's significant. Commissions, however, is a much larger item for us. We do expect that benefit that we talked about of 150 basis points is attributable to the change in how we will recognize commission expense.

Got it. Thank you.

Thank you. Our next question comes from the line of Gabriela Borges from Goldman Sachs. Your question please.

Great, good afternoon. Thanks for taking my question. Ken, over the course of last year, we talked a little bit about under-hiring in the first half and then maybe catching up in the second half. How do you feel the company is today with respect to your hiring plans? And as you look out to 2018, maybe you can just give us directional color on whether you plan - on how you plan to invest in headcount? Thank you.

Thank you. We catch up some in Q4, and we continue to keeping hiring because the sales capacity, if we can add sales capacity, we have superior product technology, especially the fabric solution is the broadest security solution in the industry. So that definitely will help us to grow. So, we'll continue to invest in the sales capacity. And we catch up some in Q4, but we'll continue to keep on hiring in this quarter.

That's helpful. And quick follow-up for Drew. You mentioned the ongoing dynamic where you're seeing duration increase. With billings guidance for fiscal 2018, is there an assumption that, that billings duration should continue to increase? And can you give us some color on how much?

This is Keith and I'll jump in for Drew on that a little bit, if you don't mind. Yes, I think, obviously, as we continue to push into the enterprise market, our enterprise customers have tended to buy longer-term contracts, be they 2, 3, even 5 years in duration. To the extent that our mix shift continues to move towards the enterprise, I would expect the duration continue to tick up just slightly as we move through the year. And I think we have that in our model.

That’s helpful. Thank you.

Thank you. Our next question comes from the line of Gray Powell from Deutsche Bank. Your question please.

Great. Thanks for taking the questions. So, I'm curious, like a number of your peers have seen decelerating product growth over the last couple of years. What do you see is the industry level of product growth going forward? And then have you seen any significant changes in the level of discounting just over the last six months? Thanks.

This is Ken. I think it's a very good question. We don't see the slowdown of the product growth. And also, like probably couple reason. The first one, we're keeping - get a new product. It's a much better performance. Like we announced today, the 6,000 series is really the fastest firewall appliance in the industry with over 100-gig of threat protection, SSL inspection. So, none of the competitor come close. We're keeping, like I said, the new opportunity, replacement opportunity, that's what's helping. The second part, also, the fabric, we have quite a broad solution, which also was helping on the product growth. But also, the longer term of the service, I think 1 year ago, we average about 22 months. I think Q4 is about 26 months. That kind of push up like a few percent of the product revenue into the future service revenue. So, if you count that one in, actually, we don't see much slowdown at all. I think it's - overall, we still see pretty strong growth in product and also the new customer base.

Yes. And Gray, this is Drew, just to add on a little bit. The unit shipments continue to grow. And I think this broad mix shift is something that you do see across the industry, as you noted. For us, just more our own, more within Fortinet, what we are seeing is growth in these enterprise bundles were higher-priced and we're selling more 7x24 support. And so, it's not all accounting, so to speak. There's economics supporting the mix shift that end up really on the balance sheet and then appear - reappear in a more profitable stream over time as we do take product costs upfront for anything shipped, any units shipped, and then that revenue comes back margin-free over time. And then on discounting, in most of the geos, it was about the same. We always have some competitive displacement. So, we saw a few of those in North Asia and maybe a few in parts of Europe, but that's really the extent of it.

Got it. Thank you very much.

Our next question comes from the line of Saket Kalia from Barclays. Your question please.

Hi guys, thanks for my questions and Drew, congrats on the move. Just two quick accounting questions from my end. First, Drew or Keith, feel free. You talked about strong growth in on-demand consumption of virtual appliances. Could you just remind us how the rev rec there works in terms of going to product or subscription and whether that changes at all with 606?

Not sure I understand the question exactly, but we certainly - I don't see any difference in how we recognize our product revenue or our service revenue. The service revenue will continue to be recognized over the length of the service contract, the product revenue upfront.

Well, I was referring specifically to kind of the virtual appliances, so not hardware, but actually, the virtual form factor?

The virtual and cloud, still pretty small percentage. I don't feel they have much impact on that.

No, you won't notice it. You will not see that in our trends.

And then also just, Saket, there's some deferred revenue that washes away given the new accounting. It just goes away. And I think for the year. And Keith, I don't serve to put words in your mouth, but I believe it's pretty much an offset.

Correct. We have - you're really talking about software licenses that are recognized currently on the subscription model in Q4 that will slip over to the upfront model, but those are fairly small dollars. And you pick up some revenue, yes, in Q1, but you've lost some amortization from the prior licenses in the prior year. That's why net-net it's...

Yes. There was some ratable software on the balance sheet. So that goes away.

Got it. That makes sense. And then maybe for my follow-up, you folks talked about just more product being deferred because of the richer services mix. And we've seen other competitors in this space kind of have the same thing. I guess the question is when do we lap that effect? And the reason why I ask is, just so we can maybe better calibrate when we could stop - maybe we can start - stop seeing that headwind on product and perhaps see a reacceleration if that is in the cards just as that effect kind of laps itself, if you will.

Well see, Saket, there's economic reality here or there's economic value being created through the mix shift with higher-priced bundles, like the enterprise bundles, which had a very nice quarter. And that's been the trend since we released those - it feels like a year-and-a-half ago. And the same thing is we ship more into 7x24 services. So, there's a continued shift in the economics as we get into the enterprise customers. And we continue to penetrate that part of the market. This can continue for quite a while. We also see a lot of headroom within our existing customers, not just by acquiring new customers, but we believe we have substantial room to grow in our installed base, upselling not only enterprise bundles, but FortiCare 360 and even higher levels of support going forward. And we'll continue to look at ways to do that.

Got it. That makes sense. Thanks very much, guys.

Our next question comes from the line of Shaul Eyal from Oppenheimer. Your question please.

Thank you, good afternoon. Congrats, Drew; congrats, Keith; congrats, Peter, on your new promotion. Ken, sales leadership, do you think that from a sales leadership perspective the company is well positioned to continue and execute well within its primary geographies?

Yes. I think we built in not only very strong product technology, also very strong team here. So, that's where in all these different areas we see pretty strong growth potential. And like I said, we are in the best position, the best time to keeping growth. And from my script, you can see in the last few quarter, we grow faster than any of our competitor based on the billing, reported billing, and also mentioned, we - the unit shipment has more than the two-close competitor combined together. So that's where we feel it's good potential Fortinet keeping growth.

Got it. So maybe, Ken, while staying on the topic and maybe from a higher level. You're probably aware of the ongoing debate touching on whether firewalls are needed in what is becoming more of a virtual infrastructure arena. What's your thinking about the topic? Is it that the hybrid infrastructure, which is the way to go? Are firewalls gradually disappearing? Is cloud completely taking over? How should we be thinking about it?

I recall in the last few years, I started to see, we go to the third generation of network security. Like I mentioned, when we started Fortinet 17, 18 years ago, we started second generation, moving from a traditional firewall, VPN, which my previous company, NetScreen, are doing for the connection security move to the - we call the application content security, just look at inside the connection, whether through UTM, next-generation firewall. So, that's doing well in the last, like 17, 18 years. I think right now maybe 80% or close to 90% the network security deployment are already using the second generation, but with all the mobile, with all the cloud, with all the IoT, just cover the network no longer enough, so you need to cover the whole infrastructure. So that's what we're starting to call is the third generation, which, including network security, but also need to addressing the cloud, the endpoint, the IoT, the access part, the application, like email and web, altogether. So that I see is a - we started promoting we call the fabric - Fortinet fabric in the last 1 to 2 years. It's a huge potential. The difference about third generation compared to the second generation, really they are not replacing the traditional firewall, that it become part of the solution. So that's where the total addressable market is bigger, but all these security piece need to be working together with network security. Network security is still the biggest in the cybersecurity, but also need to tie together with the cloud, with the endpoint, with the application, email, web, with the access control, like a AP, and also with the IoT going forward.

Thank you.

Our next question comes from the line of Walter Pritchard from Citi. Your question please.

Hi. I guess for Keith. On longer-term margin goals, could you - I guess, I didn't hear you necessarily confirm those. We have some accounting impacts and so forth, just wondering how the accounting impact the margin goals in 2020 and then and I guess, beyond that. And then a question for Ken on product. I guess on the fabric, could you maybe help us understand, which products are you most likely seeing bundled into fabric deals? I think some of these markets we're very much hearing best-of-breed purchasing areas like email security or SIEM. Just wondering, which areas are you seeing the most success on a product addition into the fabric deal.

Walter, this is Keith. And yes, we are still targeting 25% in 2020. That has not changed.

2022.

2022, excuse me, 2022, sorry, Drew. The commission impact has got a number of factors that are going into it, and that's why where we end up in 2022 with commissions would be a net change to that number. It's impacted by your mix between product and services. It's impacted by your mix by geography. It's impacted by your growth rate. There's a ton of variables that go into it. So, it's obviously pretty difficult to project that out that far. And I think that's why we're just comfortable stating again that we maintain our targets, and we'll see how the commission number plays out, whether it's accretive or not to that number in the future.

Yes. To answer your fabric, we have like we call the fabric 8. There's a top 8 product actually working together quite well with the FortiGate network security. That's including the email, the web, the endpoint we call the FortiClient, the sandbox and the FortiAP for the WiFi access control and the FortiSIEM and the FortiSwitch. So, I think like Drew also and Keith mentioned, we do win - starting to win some bigger deal that the Number 1 issue facing a lot of enterprise really, there's too many different security products and most of them not even talking or working together. So, the management cost is much higher compared to the money they spend on buying product. So that's where the fabric will help in and address all this issue. And that will tie all this together, not only different application, but also the cloud side, the remote access, the mobile, the IoT going forward. So, we see a huge potential and also the benefit to the enterprise customer to using this fabric infrastructure approach compared to just the network side. So, that's why we mentioned the fabric grow faster - the non-FortiGate grow faster than the FortiGate. And right now, it's kind about a quarter of our business, but we do see that part like grow like 25% in Q4.

Yes. And Walter, it's Drew. And I'm just trying to - I think I'm going to clarify here what Keith was saying is that the 25% was before ASC 606. And so, what he was trying to describe was you get a benefit in the early years, but in some years, it may turn around. It may turn around later. And so, it's too early to really say what that would be, but the 25% is really based pre-ASC 606, which is consistent with what we were saying in the past. Keith, is that correct?

Absolutely.

And that's why they broke it out when they did the guidance. If you look at the annual guidance in the quarter, they gave two numbers. They gave a baseline and then they gave the benefit, I believe, which was at least 150 bps, both in Q1 and for the year the way they did so you could track it.

Great. Thank you.

You’re welcome.

Thank you. Our next question comes from the line of Tal Liani from Bank of America Merrill Lynch. Your question please.

Hi guys. Just one clarification first. If you - I still didn't get what's the impact of 606 rule on your financials, if you can discuss it. And then I have two kind of bigger questions, not about the quarter. The first one is, if I go back to your roots and your focus on appliances and your strength with smaller accounts, how is SD-WAN not hurting you over the long run and all the services that branch off the service offerings - security service offerings that are cloud-based rather than appliance-based? The second question is related to that, and this is kind of at the higher level, and I think someone asked it in a different way, and I'll ask it in a simple way without getting into the details. What are the impact of cloud migration? What's the impact of cloud migration on your business given that you're very associated with high-performance, hardware-based acceleration, et cetera? Are you getting hurt or not getting hurt by cloud migration? Thanks. And I ask it - on purpose, I ask it in a very general form. Thanks.

Accounting goes first.

So, to clarify, for the revenue portion of 606, we see no significant impact in our revenue trends. Our revenue recognition model in terms of the results will look very much the same. On the commission side, we see a significant impact, where previously, we had charged to expense commissions on our hardware and services contracts and sales at the time of sale. Going forward, we will continue to charge to expense the commissions related to hardware, but for a portion of the service contracts, they will be deferred and amortized over an extended number of years. That extended number of years, I would estimate to be 4 to 6 years at this point. We'll have a final number for you in our Q1 call. You're going to see us put in the call that we are going to push out certain commission expenses that some of our competitors have already done by capitalizing them and deferring them. But at the transition day - too much accounting - we're going to capitalize an asset on the balance sheet of about $150 million related to prior commissions that will then be amortized over that period of time I described. So, you'll have a drag from the amortization of that asset and a benefit from the push of the deferral of new deals. The net effect of that is about 150 - is at least 150 basis points of improved margin in Q1 and in 2018.

Let me address your question. But before that, I think there's two things Fortinet different than all of our competitors, right? So, the first one, we're the only one building our own ASIC chip. So that's why you look in the network security, at FortiGate, we are using our own ASIC plus the best CPUs and [indiscernible] one. That gave us a much better performance and also lower the cost. So that's also making us like the Number 1 in the units shipped. So, we have more units shipped than the next two competitor combined in the network security space. So, none of our competitor have, as we are investing into the chip level, we call the SPU, gave the best performance and also much better cost in the industry. The second differentiation is really, we also build very broad security solution, we call the fabric. No other competitor has so broad solution. Also, most of them very internally developed growth from day one, making them working together. So, some of our competitor keeping buying different product, different solution and try to put it together, but we build it internally day one, making it working together. So, that's also differentiates us from our other competitor. So, for your question, like SD-WAN, there's a few SD-WAN player in the industry right now, but the current SD-WAN solutions are very low cost. They lack the computing power to address any security issue. So, they don't have any computing power to address all this security computing needed. I believe SD-WAN need to be integrated just like AP need to be integrated with network security and security is a very important part going forward. So that's where we have huge advantage because our solution combined with the SPU ASIC, which has huge computing advantage, computing power performance advantage compared any other SD-WAN solution. Also, for the cloud, we do have all the major cloud provider working with us. We have the best cloud solution. We see that grow also very fast. But also, just cloud is not enough. You still need to address the network side, the endpoint side, the application side, the IoT side. So that's why we say cloud is one of the growth engine we identify. We have 4 growth engines. So, the network security's still keeping growing, still the biggest market in cybersecurity, and then go beyond that, it's the fabric, cover additional endpoint, the access part, the email application, web application, the FortiSIEM, and then the cloud, it grow very fast, but a little bit small base right now. And then IoT has even more great potential going forward. We don't see any of our competitor really addressing that. And also, just in the last month, in the CES show, we are probably the only security company, we demonstrate how to secure the connected car using our solution. So, that's also a huge potential going forward.

Got it.

Thank you. Our next question comes from the line of Fatima Boolani from UBS. Your question please.

Good afternoon. Thank you for taking my question. Just the first one for Keith. Keith, as we think about the size of your installed base, you have a pretty latent opportunity in terms of refreshing that base. So, as your portfolio has expanded and you've invested in and around the fabric messaging, can you help us understand what refresh trend you're seeing and the cadence of refresh you're seeing in your base relative to historical trends? And then a quick follow-up.

Yes. Like I mentioned, there's three opportunity: the new opportunity and then the displacement and also the adjacent market like SD-WAN. For the refresh, like I said, every 4, 5 years, the network security hardware need to be refreshed. So, we see the last cycle happen in like 2014, 2015 in our discussions because somehow the Moore's Law still apply every 18 to 24 months. The speed need to be double. And also, the network security tend to be 100x slower and about 100x more costly - 100% throughput compared to the network in routing and switching. So, that's what's continue to apply the rules, continue to apply in this going forward. So, we do see the refreshing cycle happen every 4, 5 years for the enterprise customer or even for SMB in this industry. And then that's why whoever can come up a better performance and the additional function, lower the cost, who has advantage. We believe we are the only one can go to the chip level, has huge advantage on the performance and the cost with a refresh and then add additional computing power just like some other GPU, TPU can address in some separate space. It's a huge advantage. It's a 7-to-8-year advantage on the performance on the cost compared to the software on a general-purpose CPU, most of the competitor do. And then also for the refresh, a lot of times the Number 1 issue enterprise customer facing is too many different products. And they are not talking. They're not working together. So that's the fabric also come in. So, we see a lot of deal, a lot of big enterprises, they need to address how the network security can - working together with endpoint, with the cloud, with other like email, with web security, with their WiFi access, with all the switch and also a - so a lot of thing need to be working together because the management cost is still the highest cost among all this enterprise security. It's not really the product; it's how to provide better management. So that's the fabric where we help address it. We not only develop our own kind of a very broad fabric solution, but also, we have very broad partner, like I mentioned, pretty much all the major networking company, the software company, the database company, the cloud company is our partner. This is the broadest partner program in the industry, making all this fabric working together. So, we have a 37 eco partner, including today, this morning, we announced with Google Cloud.

That's really helpful, Ken. Thank you. And Keith, a quick follow-up for you. Any guideposts you can share around how we should think about cash flow? And you've historically been a modest cash taxpayer and with the rate coming down, if you can help us sort of wade through that and provide some guideposts on cash flow, that would be really helpful? Thank you.

Yes. As you know, we don't guide on free cash flow, but having said that, in terms of cash paid for taxes, you can compare 2017, we paid $32 million. We project $40 million to $44 million in cash paid for taxes in 2018.

Thank you.

Our next question comes from the line of Ken Talanian from Evercore ISI. Your question please.

Hi guys. Thanks for taking the question. So, I think you've previously talked about seeing margins expand about 150 to 200 basis points from 2017 and beyond. And I believe that was without the impact of 606, but your current guidance seems to suggest less expansion and I was wondering what might be driving that change?

Ken, this is Drew. And when we did it, the 150 to 200 was off 2016 guidance, which at the time would have been 16.2% for 2017. So, we're on track. If you go 150 up, that's 17.70% to 18% would get you in that range, I think, pretty easily.

Yes. Also, like I mentioned, we're a little bit behind our hiring last year, especially the sales. So, we started the setup in - towards end of Q3, Q4. That's starting to catch up. But also, we believe with the best product in the industry and if we can add additional sales capacity, plus the fabric expanded market opportunity, we definitely can grow faster than the market, keep on gaining market share.

Okay, great. Thanks very much.

Thank you. As we are coming to the end of the hour. Our final question comes from the line of Brad Zelnick from Credit Suisse. Your question please.

Great. Thanks so much for fitting me in and congrats, Drew, and everybody else over at Fortinet. My first question for Ken. Ken, it's nice to see that you've now got all the major public clouds covered with the GCP announcement today. Can you maybe talk a bit about, architecturally, how the virtual product compares with physical product if the public clouds themselves don't expose the lower layers of the OSI stack? And when we think about cloud and virtual product, how much of that is really being run in the public cloud versus customers using virtual editions of the product in their own virtualized networks?

Yes. It's good question. We do have the best software, which also the Forti SPU help accelerate that. So that's where I feel the cloud, you need to have both side working together. And the same time, even some cloud provider, they recognize it's very expensive to run on some of the security function in a general-purpose CPU, right? So that's where - there's like a - the purpose-built, chip-level solution can really help in accelerate the performance, also lower the cost, but also some cloud, they want to have certain flexibility. So, basically, based on our very broad approach, the huge installation base and also the combination of the fabric part, and - we see is a huge advantage compared to our competitor, which like where they play in the network security or in the cloud space. And that's where the fabric, we feel, is much better approach compared to the traditional, whether on the network side or just on the cloud side. You do see - if you only compare on the general-purpose CPU running on the cloud, there's probably not much differentiation, but with acceleration of the ASIC and acceleration of the broad fabric approach and combined together, that's a much better position, advantage compared to our competitor. So, that's why I do believe going forward even a cloud provider itself need to address how to increase the performance, also lower the cost of the cloud security computing they're facing right now, especially, like I mentioned, like today is the 6,000 announcement. They can address like a 100-gig throughput of SSL inspection. That's all the cloud provider also needed. This is the highest-performed appliance. And I specifically mentioned in the script, it's addressing the transition to the cloud because all the cloud provider and also for enterprise customer and the end user, they also need to have a secured access to the cloud data, which SSL encryption is a major part of it.

Thank you, Ken, that's very helpful context. And if I could just slip one in for Keith or perhaps Drew. If I look at your slide deck and I go to the slide on the ASC 606 impact, I appreciate that the comments suggest that there really isn't any material change to revenue recognition, but if you look at the shift from selling through to selling into the channel in 2018 under 606, it makes me wonder. Is there even a timing benefit or headwind in selling into the channel? And as it relates to that, can you just maybe remind us on your inventory policy as we think about what sits out there in the channel?

Historically, we do not put a lot of inventory in the U.S. channel. It's not been a significant dollar amount. And I don't know that we would expect to see a significant change in that regard related to 6 - due to 606 in the first quarter. I think you can check our financial statements and see our inventory in the channel.

I think he's also - Brad's also asking if there's an impact from - to the sell-in basis. Brad, not to ask a question for you, but…

No, no, that is the essence of the question though. As you go from sell-through to sell-in, I would think that there's a bit of a timing benefit. And also, the related question as well, does it relate to billings or is it only impactful to revenue, even if a small impact?

I think it pretty much offsets in the quarter the amount of revenue - the amount of inventory we expect to put into the channel in the U.S. is pretty much offset by the revenue that we lose from deferred revenue coming in due to the change.

So, it's not a material impact.

Thank you very much.

Thank you. And this does conclude the question-and-answer session of today's program. I'd like to hand the program back to Peter Salkowski for any further remarks.

Great. Thank you. As a reminder, we will hold a second conference call at 3:30 Pacific Time this afternoon. The dial-in information for that call is on our Investor Relations website to do a Q&A session. I'd like to thank everyone for your interest in Fortinet and have a good day. Operator, this includes the fourth quarter and 2017 earnings call.