Fortinet Q4 2022 Earnings Call Transcript

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February 7, 2023

Key Takeaways

  • Fortinet achieved 32% full-year revenue growth to $4.4 billion, 42% product revenue growth, 34% billings growth to $5.6 billion, record free cash flow of $1.45 billion, and a 27.3% non-GAAP operating margin.
  • In Q4, billings hit $1.7 billion (+32%) and revenue reached $1.3 billion (+33%), driven by a record 6,200 new logos, 43% product revenue growth, and 27% service revenue growth.
  • Seven-figure enterprise deals surged 55% to 546, with key competitive upsells consolidating multiple vendors across global networks and demonstrating Fortinet’s converged platform appeal.
  • Launched the 5th generation FortiSP5 ASIC, delivering 17–32x performance gains and doubling acceleration for critical applications, underscoring Fortinet’s networking and security convergence leadership.
  • Guidance for Q1 2023 calls for $1.415–1.465 billion billings (+24%) and $1.18–1.22 billion revenue (+26%), with full-year guidance of $6.71–6.79 billion billings (+21%) and $5.37–5.43 billion revenue (+22%), reaffirming the 2025 targets of $10 billion billings and 25% non-GAAP operating margin.
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Earnings Conference Call
Fortinet Q4 2022
00:00 / 00:00

There are 15 speakers on the call.

Operator

For standing by, and welcome to the Fortinet 4th Quarter Earnings Conference Call. At this time, all participants are in a listen only mode. After the speakers' presentation, there will be a question and answer session. As a reminder, today's call is being recorded. I I would now like to turn the conference over to your host, Mr.

Operator

Peter Sawlowski, Senior Vice President of Finance and Vice Investor Relations. Please go ahead.

Speaker 1

Thank you, Valerie. Good afternoon, everyone. This is Peter Salkowski, Senior Vice President of Finance and Investor Relations at Fortinet. I'm pleased to welcome everyone to our call to discuss Fortinet's Financial results for the full year and Q4 of 2022. Speakers on today's call are Ken Z.

Speaker 1

Fortinet's Founder, Chairman and CEO and Keith Jensen, our Chief Financial Officer. This is a live call that 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. Keith will then review our financial and operating results for the full year Q4 of 2022 before providing guidance for the Q1 of 2023 and the full year. We'll then open the call for questions.

Speaker 1

Before we begin, I'd like to remind everyone that on today's call, we will be making forward looking statements, and these forward looking statements are subject to risks and uncertainties, which Could cause actual results to differ materially from those projected. Please refer to our SEC filings, in particular, the risk factors under Washington Form 10 ks 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 2 update forward looking statements. Also, all references to financial metrics that we'll make on today's call are non GAAP unless statements are otherwise. Our GAAP results and GAAP to non GAAP reconciliations are located in the earnings press release and in the presentation that accompany today's remarks, both of which are posted on the Investor Relations website.

Speaker 1

Ken and Keith's prepared remarks for today's earnings call will be posted on the quarterly earnings section of our Investor Relations website immediately following the call. Lastly, all references to growth are on a year over year basis unless noted otherwise. I will now turn the call over to Keith.

Speaker 2

Thanks, Peter, and thank you to everyone for joining today's call to review our outstanding full year and Q4 2022 results. For the full year, revenue growth accelerated to 32%. We continue to gain market share in the cybersecurity industry With customers increasingly recognizing how Fortinet integrates at a single platform approach to security delivers a low Total cost of ownership and a greater return on investment than competing solutions. Pointline revenue growth of 42% was very strong, making Fortinet a leading product revenue company in the cybersecurity industry with total product revenue of RMB1.8 billion. MSD WAN and OT bookings together accounted for over 25% of total bookings.

Speaker 2

And our goal is to keep growing and She's the number one market share in network firewall, secure SD WAN and OT security market over the next couple of years. For 20 years, Fortinet has lead long term strategies and investment around the convergence of networking and security. Yesterday, we announced our 5th generation Forti secondurity processor, the Forti SP5. This new SoC base for ASIC has secured computing power reaching for major network security functions like firewall and VPN So we report that are 17 to 32 times greater than the average of our competitors' similar price model using general purpose CPUs And it doubles the ASIC chip acceleration of applications to 14, such as New Trust, SaaS, 5 gs and IC Branch with much better performance and efficiency. According to the most recent IDC data on unit shipment of firewall appliance, Fortinet hold the number one unit shipped Market share position at 48%, providing Fortinet with an attractive economy of scale position as well as making it difficult for competitors to develop their own ASIC technology due to high Entry barrier and significant investment not is required.

Speaker 2

4 gs is a huge security company power Advantages are able FUDA OS to integrate more security functions and applications than our competitors With much better performance and much lower energy consumption, resulting in a much lower total cost of ownership While offering easier operations for our customers, for example, a recent Forrester report I highlighted that customers deploying Fortinet secure SD WAN solutions achieved a 300% return on investment over 3 years With a payback period of only 8 months, Fortinet's substantial installed base of product with rich functions Enable us to offer additional secure services and upsell, integrate and automate FortiFabric product and solutions. We recently announced several new and enhanced services that help SoC team reduce their operations' cyber risk Why be more efficient in handling cybersecurity issues? As networking and security continue to converge and consolidate, We believe we are well positioned to achieve our 2025,000,000,000 target of $10,000,000,000 Before turning the call over to Keith, I would like to thank our employees, customers, partners and suppliers worldwide

Speaker 3

Thank you, Ken, and good afternoon, everyone. As we look back at 2022, We see the success of our strategy to lead in convergence and consolidation as well as the combined power of our ASIC technology with our integrated operating system. Combined, these efforts are driving our strong financial results. There's been an explosion of devices that must be connected to the cloud, data center and edge compute. As a result, the infrastructure has expanded to support secure connectivity via distributed firewalls.

Speaker 3

It is no longer feasible to overlay security on networking in the data center. They must be deployed as the converged solution. Firewalls need to work seamlessly with networking and security applications across the company's entire infrastructure. Fortinet is leading the convergence trend with a wide range of technologies, including network firewalls, Secure SD WAN, 5 gs and OT security, all embedded in our single operating system delivered as hardware, software, cloud and as a service. Traditional CPU based solutions are very inefficient at supporting both networking and security.

Speaker 3

That's why Fortinet developed proprietary ASIC technology To build an application specific solution, yesterday, as Ken mentioned, we announced our next generation ASIC, The Forti Security Processor or Forti SP5, which allows line speed convergence of networking and security at every network edge. The new 7 nanometer technology combines existing NP7 technology with new contents processor capabilities. Our enhanced platform suite of integrated products is delivering on customer demands for convergence, vendor consolidation, ease of management And lower operating costs. The success of the strategy is evident in our full year 2022 results, and I'll start there. Billings passed the $5,000,000,000 mark, totaling $5,600,000,000 and growing 34%, While revenue totaled $4,400,000,000 with growth accelerating to 32%, the 5th consecutive year of revenue growth of 20% or more.

Speaker 3

Driven by strong demand for our fabric and cloud security solutions, enhanced platform technology billings and revenue Both increased over 40% to $1,800,000,000 $1,500,000,000 respectively. And despite a challenging global supply chain environment, Product revenue growth came in at 42%, our highest annual product revenue growth rate in over 10 years. Our product revenue growth was driven by the combined excuse me, by the continued growth of our firewall use cases And the addition of over 23,000 new customers, service revenue was up 26 percent to 2,600,000,000 resulting in 3 consecutive years of accelerating service revenue growth rates. Gross margin was strong at 76.3% And operating margin outpaced our initial expectations, increasing 110 basis points to a new for a net record high Of 27.3 percent. Our GAAP operating margin of 22% is one of the highest in the industry, And we continued our streak of being GAAP profitable every year of our 14 year history as a public company.

Speaker 3

Earnings per share increased 49 percent to $1.19 Free cash flow was a record at 1,450,000,000 Free cash flow margin was 33%. And adjusted for real estate investments, the free cash flow margin came in at 37%. And for the year, we repurchased approximately 36,000,000 shares at a cost of $2,000,000,000 Total deferred revenue increased 34 percent to $4,600,000,000 Short term deferred revenue increased 32% to 2,350,000,000 Quarterly contract terms throughout the year were consistent with the year earlier periods, including the Q4 at 28 months. Before moving on to our Q4 results, I'd like to summarize our enterprise success and highlight a few 7 figure deals from 2022. We saw great success during the year with our strategy to expand further into the large enterprise segment as the number of deals over $1,000,000 Increased over 55 percent to a record 546 deals and billings on these deals increased by over 70%.

Speaker 3

If we look at a few of our large deals of the year, let's start with a competitive upsell deal. Fortinet displaced 11 different vendors By consolidating the customer's network, the security functions on our security fabric. This worldwide wholesaler Previously purchased Secure SD WAN and 40 Proxy. Next on the list was a centralized network security solution It could be managed and deployed to its 400 global locations. This customer chose Fortinet Security Fabric For a flexible and integrated solution across multiple scenarios, including work from anywhere, perimeter security and data center segmentation.

Speaker 3

In another upsell deal, a leading global manufacturer was spun off and had to stand up their security and networking infrastructure separately. The newly created infrastructures included remote access, SD WAN, application delivery control, authentication, endpoint, Email protection and switching. Keys to our win included our 0 trust capabilities, a cloud first SD WAN strategy And the ease of integration and convergence across our platform suite. Lastly, in the new logo win, A large U. S.

Speaker 3

Retailer with over 500 locations was struggling with the total cost of ownership of their legacy security architecture. Keys to this win included delivering a single pane of glass versus the multiple consoles that we're using and replacing the competitors' firewalls With our FortiGates delivering URL filtering, Wi Fi security and edge router replacement, all on our unified and integrated FortiOS platform, This customer reported anticipated savings of $29,000,000 over 5 years. Turning to Q4 results, both billings and revenue delivered new Fortinet records with billings of 1,700,000,000 And revenue of $1,300,000,000 both metrics increased over 30%. The strong 4th quarter revenue performance reflects Solid customer demand across both our core and enhanced platform technologies. In the Q4, we added over 6,200 new logos, Another new Fortinet record, reflecting the support of our channel partners, the leverage they bring and the breadth of our worldwide customer base.

Speaker 3

Taking a closer look at the Q4, billings growth of 32% was driven by a 40% increase in enhanced platform technology billings, Which accounted for over 1 third of total billings. Total revenue growth of 33% was driven by strong demand for core and enhanced technology platforms, Which increased 26% 47%, respectively. Product revenue grew 43% to 540,000,000 Service revenue was up 27% to $743,000,000 driven by strong product revenue growth and strength in our security subscriptions. Short term deferred revenue grew 32% and represents 8 consecutive quarters of accelerating growth rates. Total gross margin of 77.6 percent was driven by a 310 basis point increase in product gross margin to 65.2%.

Speaker 3

Several factors converged to drive our record high quality product gross margin, including legacy pricing actions, Easing supply chain cost pressures and improved discounting. Service gross margin of 86.7% ticked down 40 basis points due to increased labor costs and our expansion in cloud services and the related hosting costs. Operating margin of 32.5 percent was up 400 basis points year over year due to the strong gross margin performance and FX benefit. Looking to the statement of cash flow summarized on Slides 11 and 12. Free cash flow was 497,000,000 Adjusted free cash flow, which excludes real estate investments, was $510,000,000 representing a 40% adjusted free cash flow margin.

Speaker 3

Cash taxes were $63,000,000 capital expenditures were $31,000,000 including $13,000,000 for real estate investments. DSO increased 14 days sequentially and year over year to 89 days, also impacting service revenue growth. Moving to guidance. We believe the continued innovations we've made in building our platform enables our customers' digital transformation journey. And as Ken noted, customers are increasingly recognizing how Fortinet's integrated and single platform approach to security Can deliver a lower total cost of ownership and a greater return on investments in competing solutions.

Speaker 3

Now I'd like to review our outlook for 2023, summarized on Slide 15, which is subject to disclaimers regarding forward looking information that Peter provided at the beginning of the call. For the Q1, we expect billings in the range of $1,415,000,000 to 1,465,000,000 which at the midpoint represents growth of 24 percent revenue in the range of 1,180,000,000 To $1,220,000,000 which at the midpoint represents growth of 26%. Non GAAP gross margin of 75% to 76%, Non GAAP operating margin of 23% to 24%, which at the midpoint represents an increase of 150 basis points. Non GAAP earnings per share of $0.27 to $0.29 which assumes a share count of between $795,000,000 $805,000,000 Capital expenditures of $80,000,000 to $110,000,000 non GAAP tax rate of 17%, cash taxes of $20,000,000 And should also note the Q1 guidance assumes backlog decreases slightly during the quarter. For the full year, we expect Buildings in the range of $6,710,000,000 to $6,790,000,000 which at the midpoint represents growth of 21%.

Speaker 3

Revenue in the range of $5,370,000,000 to $5,430,000,000 which at the midpoint represents growth of 22%. Total service revenue in the range of $3,335,000,000 to 3,365,000,000 Which at the midpoint represents growth of 27% and employees it implies a 4th consecutive year of accelerating service revenue growth. The service revenue guidance also implies product revenue growth of 15%, non GAAP gross margin of 75% to 76%, Non GAAP operating margin of 25% to 26% non GAAP earnings per share of $1.39 to 1 0.41 which assumes a share count of between $805,000,000 $815,000,000 capital expenditures of $400,000,000 to $450,000,000 Due to continued investments in clouds, data centers and facilities, non GAAP tax rate of 17%, Cash taxes of $375,000,000 split somewhat evenly between the first and second half of the year. The increase in cash taxes reflects recently effective R and D capitalization and amortization requirements. The full year estimate Assumes backlog approaches historical levels by the end of the year.

Speaker 3

Cybersecurity, though not immune to economic slowdowns, It's expected to remain a comparatively safe harbor. And with a strong business model and history of execution, we are confident that our market share gains will continue. We remain on track to achieve our 2025 financial targets, which include billings of $10,000,000,000 revenue of $8,000,000,000 Non GAAP operating margin of at least 25% and adjusted free cash flow margin in the mid to high 30% range in 2025. And with that, I'll now hand the call back over to Peter to begin the Q and A session.

Speaker 1

Thank you, Keith. Operator,

Speaker 2

Open up the call please, Peggy.

Operator

Thank you. Our first question comes from Brian Essex of JPMorgan. Your line is open.

Speaker 4

Great. Thank you. Good afternoon and thank you for taking the question and congrats on some solid results and a solid guide. I guess, Given that we heard from one of your peers last night and they were, I guess, markedly more Conservative or cautious on the macro than you seem to be. Maybe for Ken and Keith, could you help us understand what you're seeing in the market from a macro Perspective, how enterprises are spending and how did any changes in the quarter relative to Initial expectations pan out with regard to demand.

Speaker 4

We're seeing sales cycles you're hearing about sales cycles elongating and budget scrutiny Ongoing. What are you seeing on your side?

Speaker 2

I do get a Question feedback from some customer partner. Their budget is tight, but Fortinet Solutions has a better Cost of total cost of ownership and also kind of even cost saving for some like a secure SD WAN solution. And at the same time, we do see the use case of firewall expanding much Broader than before, especially for this OT security, some other area, which pretty much I say, Maybe the only solution to secure some of this OT area. So that's what we see that The demand is still pretty strong, and so we are probably we're keeping gaining more market share in this rather fragmented market.

Speaker 3

Yes. Thanks, Ken. I would spot on with that. I would also ask, look, I think we're all sensitive to that, the overhang from the macro environment and what that may mean as we progress. But when we look at our internal numbers, whether it's pipeline growth and even if we compare what pipeline growth is today versus a year ago, it's even up from there in terms of percentage growth rates.

Speaker 3

The use cases and I think in this environment, the savings that we offer and the ROI that we provide and some of the case studies that we provided in the call there are Examples of that. I think that we're continuing to benefit from that and we do see the continued opportunities for market share gains even in this environment.

Speaker 4

Got it. Maybe just for a quick follow-up then, Keith. As you think about the level of conservatism in your fiscal 'twenty three guide, I mean stronger than I think Somewhat expected, and I'm going to get the question tomorrow, how much conservatism is in there? What gives you confidence And hitting that kind of level of performance, particularly with regard to billings, and then any change to your 2025 targets as you kind of look at The strength that you're seeing in the market from here on out?

Speaker 3

Yes. I think that the approach that we take, if you will, is consistent this time around with What we've done in prior years, but with it certainly added conservatism in it to reflect what's happening or what may happen with the macro environment. And 1st and foremost, we start with the pipeline. And looking at the pipeline growth there, and the kind of timing of the pipeline and making sure that we have deals that are teed up for The middle of the year and perhaps even into the second half of the year. So there's ample opportunity there.

Speaker 3

You also want to make sure that you've got sales productivity numbers that make sense and sales I'll ask the numbers that make sense. Yes, I think there will be some tailwind from the backlog, which I commented on in the comment that we're going to get some benefit from that as it continues to burn down. But keep in mind that we have seen some changes in cancellation rates and I think we've added a significant amount of conservatism there around cancellation rates. Again, so I think it's really about the pipeline. It's the tailwind that we have, and I think it's the advantages that we're offering in total cost of ownership in this environment.

Speaker 4

Okay. That's super helpful. Thank you very much.

Operator

Thank you. One moment, please. Our next question comes from the line of Fatima Boolani of Citi. Your line is open.

Speaker 5

Hey, good afternoon. Thank you for taking my questions. Keith, for you, just with respect to the services revenue guidance at 27%, That's not a material difference from the cadence you've been running at this year. And I'm curious, what sort of inputs Embed that revenue segment for you? And I ask because we have a dynamic Some of your customers delaying their subscription registrations over the course of 2022.

Speaker 5

And then we also have the dynamic of a lot of your customers Not having realized the pricing increases that you've affected in the last 12 to 18 months. So I'm curious as to why with those positive inputs, you we wouldn't see better services growth and what sort of Things that you're being conservative about there? And then a quick follow-up, please.

Speaker 3

Yes. I think it kind of goes back to Brian's question a moment ago in terms of with the level And I know that historically, I've often complained that I don't get much room in the services line from where the consensus is versus what I'm forecasting. At a 27% number, I think that's pretty much right on top of where the Street is at for the full year. And I think in this macro environment, I think that's A great a good place for us to be at this point in the year for full year guidance.

Speaker 5

Understood. And any commentary on operating margin and operating profitability performance, because we are seeing compression into next You're certainly on a quarterly basis, but anything to be mindful of there as it relates to maybe one time items that are peeling out, Just perhaps why not see better follow through on profitability? And that's it for me. Thank you.

Speaker 3

Yes. I think our guidance is pretty much in sync with where we are historically at this point in time and consistent with what we always talk about the 25% margin number. But I think that what you may be suggesting or inferring is really it's all about FX, if you will, when you look at 2022 compared to 2023. We had a nice benefit from FX in 2022. And I think in terms of what our assumptions are for 2023, like the rest People, we read the economic reports from the big banks and so forth and what the dollar is expected to do.

Speaker 3

And I think we've really pulled out a lot of that benefit by the end of this year. So you're not really going to see that in the year to year comparison.

Operator

Thank you. One moment please. Our next question comes from the line of Saket Kalia of Barclays. Your line is open.

Speaker 6

Okay, great. Hey, guys. Thanks for taking my questions here. Maybe first for maybe a question for both Ken and Keith. Clearly SD WAN and OT are becoming a bigger part of the business and that too with higher growth rates.

Speaker 6

And so maybe the question is, How do you folks think about the growth rate or runway for growth in those two businesses either separately or together Over the next couple of years, as part of the total growth equation or part of the $10,000,000,000 goal, however you want to think about it, but really curious about That SD WAN and OT part of the business that's been doing so well?

Speaker 2

I think there's a 2 part. First, I totally agree with you, say the SD WAN and OT market growing faster than the network security average. And On the other side, we do believe our solution has huge advantage compared to other competitors. So both SD WAN OT market is still pretty fragmented and compared to our home growth integrated solution and leverage for the AC company in So all the advantage is much huge compared to other competitors. Quite some mostly come from acquisition.

Speaker 2

And at the same time, they don't have the ASIC hub to increase speed, lower the cost and the power consumption. So that's why we feel we're keeping growing above the market, so that about the market growth rate. There's a different research about how the market growing, But I do agree, it's a fast growing market compared to the cybersecurity space and will be a lot of potential going forward.

Speaker 6

Got it. Got it. Very helpful. Keith, maybe just a quick follow-up for you. Actually, great to see the billings durations stay roughly similar.

Speaker 6

I'm curious if you could just talk anecdotally or just specifically just around how you're thinking about billings duration here in 2023. And whether that's been something that you feel like customers have pushed on given the interest rate environment that we're in?

Speaker 3

Yes. I don't think that we're really seeing customers push on the term, obviously, at 28 months, which is kind of in keeping where we've been historically.

Speaker 4

I do think in

Speaker 3

the Q4, we certainly had conversations with customers that were, I think, perhaps even more focused on cash flow, if you will, Than they were on discounting in terms of extended payment terms and that sort of thing. So if I were to look at what I'm hearing back from customers, it was all about cash protection. And with that, I assume if I were trying to do a lot of 5 year deals or something like that, I might have felt more pressure. But given the SMB mix of our business and our partner footprint, Obviously, it didn't come through in the numbers really.

Speaker 6

Yes, absolutely. Great to see. Thanks, guys.

Operator

Thank you. One moment please. Our next question comes from the line of Hazmat Poddarala of Morgan Stanley. Your line is open.

Speaker 7

Hey, guys. Thank you for taking my question. Good evening. Keith, I wanted to clarify something you said about the Cancellation rates, I think you mentioned that you're seeing some changes there. Can you maybe elaborate on that a little bit?

Speaker 7

I think like the past few quarters, it's been around 4% or 5%. Just If you could provide any more color on that comment?

Speaker 3

Yes, we did see it tick up to if we want to call it mid single digits in Q3. We saw it tick up to high single digits In Q4, in Q4. And we've anticipated this particularly as the backlog starts to shift its mix as the firewalls There's still a significant amount of firewalls in the backlog, but it really now has tilted towards the network equipment, the switches and the access points. And so as you would expect one last comment on that as we see the shift in the mix as a backlog as well as a pickup in the cancellation rates, would also offer that as part of the guidance setting process, I think we've taken a fairly conservative approach to cancellation rates and what they how they may impact 2023. Or said another way, we're not expecting all the backlog that exists at the beginning of the year to convert in 2023 because we think there'll be some cancellations.

Speaker 7

Got it. And just maybe a follow-up for Ken. I think SD WAN is now nearly $1,000,000,000 business for For Fortinet, which is quite remarkable because you just started selling it, I think, maybe 4 years ago. I'm curious as more of that base starts to come up for refresh, What other monetization drivers do you see for SD WAN, whether it be attaching more services or perhaps Increasing the price points, curious how you're thinking about that?

Speaker 2

Yes, definitely more service, whether Android overlay service For SD WAN, because SD WAN has all the security function and also a lot of SD WAN deploy case As well as supporting work from home or work from anywhere or kind of helping enterprise reduce their total cost Of networking, all these things, we do see a lot of additional service they need. At the same time, we also see the service provider Starting more working together with us, offer some quite additional service beyond the traditional SD WAN. So that's also helping drive much more service Going forward.

Speaker 7

Thank you.

Operator

Thank you. One moment, please. Our next question comes from the line of Brad Zelnick of Deutsche Bank. Your line is open.

Speaker 8

Great. Thank you very much and congratulations on Just blow out results and guidance. Nice job. My first question is just around the new ASIC 40 SP5. Can you remind us what, if any, impact we might expect in terms of customer purchasing patterns and what you've seen in the past and the extent Perhaps it can drive accelerated demand and or maybe the risk of trade down effect?

Speaker 8

And I've got a follow-up. Thanks.

Speaker 2

Probably, it will take some time, I'd say, maybe 1 to 2 years to refresh The product. And that's where every quarter we tend to release 1 or 2 product, whether leverage new ASIC The new CPU of some other network chip in the industry, I don't feel it will be significant impact Up and down of the result, it will be more smooth transition because security deployment It's kind of a take long time to design, evaluate, deploy and also very, very long sales cycle. At the same time, The life cycle of the product also tend to be quite long, like 7 to 10 years. So that's where the ASIC definitely each generation definitely will help And at the same time, that's huge advantage compared to using general purpose CPO. So that's where we're keeping gaining market share.

Speaker 2

But consider the switching costs compared to the long cycle sales cycle and deployment cycle. And also we also need a Han, to put ASIC into a new product, which also take at least a few months, 3 to 6 months, as I do see It will be like a more long term positive impact instead of short term.

Speaker 3

Yes, Brad, I would only offer again for context, I think that This is what Fortinet has done 20 generations of chips probably now within content processors and network processors and systems on a chip. And I think that Ken and Michael have actually shown the ability to transition through those generations of chips. And if you look back at the financials, I think it's a little bit difficult Find a year that for a period of time we really saw a spike because of the new chip. These are much more long term plays. And I think the approach here is to execute it in a smooth fashion

Speaker 8

Thanks for the reminder. And Keith, can you just expand on your comments around DSOs Being up sequentially year on year and the impact of services revenue. And related to that, I recall you had a change in policy around subscription activations. Is that also impacting services revenue? Any help there would be great.

Speaker 8

Thanks.

Speaker 3

Yes. The change in activation policy started February last week, I believe, February 1. So we'll start to see that going forward. What I was referring to is the DSO is really all about linearity, right? That's what it gives you insights to.

Speaker 3

And if I see my DSO go from, call it, 75 days to 89 or 90, you can kind of start doing the math there and see that's a 20% Increase in DSO and it's really driven by how linearity came through in the quarter. And when linearity starts shifting that much, Yes, we lose the opportunity to gain service revenue from sales early in the quarter that would normally activate. So we really didn't get a lift Service revenue from in quarter deals the way that we would have expected because of linearity.

Operator

Thank you. One moment please. Our next question comes from the line of Shaul Eyal of Cowen. Your line is open.

Speaker 4

Thank you. Good afternoon and congrats on the great performance and guidance. Keith, given the slightly lower than expected 4th Q service revenue, How should we be thinking about the Q1 service revenue growth?

Speaker 3

Yes. I think that we've kind of remained truthful to or faithful to the notion of providing service revenue guidance for the full year, I'm going to kind of let The Street work out the numbers from that point going forward. I think that Certainly, as we kind of looked at laying out the year and with the backdrop of the macro that we're all concerned about, I don't think we really wanted to push too hard on some of the metrics that we didn't need to push on. I think where we ended up with is pretty consistent in the quarter Yes, with our consensus, when we look at our internal allocations between product and service revenue.

Speaker 4

Understood. And maybe one more. As we think about the non GAAP operating margins and really great performance, should we be thinking of the target To be some sort of an average of 25% over the period or a floor of 25% over the course of the next few years.

Speaker 3

I'm going to answer yes. Yes, you should be thinking about one of those two ways. Look, I think we're driven by being above 25% Operating margin, right? I think the ones that the last few years have taught us is life's full of surprises. And so locking into a fixed commitment is a little bit Challenging sometimes, but clearly we manage the business as if it's a floor.

Speaker 4

Understood. Thank you so much.

Operator

Thank you. One moment please. Our next question comes from the line of Adam Borg of Stifel. Your line is open.

Speaker 9

Awesome. Thanks so much for taking the questions. Maybe for Ken or Keith, just on sales headcount. Obviously, you guys have been aggressively growing Sales and marketing headcount in recent years, and it's nice to see the enterprise success you talked about. Just curious where we are in sales force productivity And how we should think about sales headcount growth and even overall headcount growth in 2023?

Speaker 9

And I have a follow-up.

Speaker 2

Yes. We are continuing hiring, but at the same time, we want to keeping the efficiency, And it's not dropping the efficiency for the sales marketing. And at the same time, there's some long term investment, whether in R and D, the infrastructure Supporting, we will continue to need to make. So that's why we do expect that the total headcount will keep an increase, but Probably the rate that just like the last few years will be below the top line increase.

Speaker 3

Yes, I think I would This is Bill and Ken's comment. One other note is that we do track tenure. We talked about it last quarter. Tenure would be people that have been here for say, tenured people have been here for more than 6 months. And I commented last quarter that tenure was up, I think, 8 points.

Speaker 3

It's actually moved back to historical norms now. And tenure is kind of a key component of productivity As we go forward. Got it.

Speaker 9

And maybe just a quick follow-up just on the FortiGate and entry mid and high. It's nice to see Really strong mid range growth. It's interesting at the high end, at least by biomass with the lowest mix since 2017. Just curious anything to comment there? Thanks so much.

Speaker 2

That sometimes depends on certain like a product or backlog. I think that's probably the average still pretty similar. We don't see much up and down, but sometimes on quarter to quarter, it may change a little bit. But I have to say the total mix is still pretty much the same.

Speaker 3

Yes. I think that's one of the challenges you have in the current environment when the supply chain It's really doing funny things, if you will, into delivery. And we don't give you a lot of insights to orders that we were taking in, but we provide billings numbers. You get some distortion there just simply based upon what's available. Specifically, we saw a significant amount of availability of the 100F products, if you will, which are a mid range product.

Speaker 3

And you're seeing that availability come up came in the 4th quarter and it shifted that mix in the way you just described it.

Operator

Thank you. One moment please. Our next question comes from the line of Tai Liani of Bank of America. Your line is open.

Speaker 10

Hello. Thank you. This is going to be one day a call that no one is going to butcher my name and I'm going to be very happy. But I wanted to ask you 2 things. First of all, Could you provide a backlog for 4Q or anything about it?

Speaker 10

I'm trying to calculate the bookings For the year and what happens to bookings and any color on backlog would be great. And the second question, A few people asked you about the services growth for next year. I want to ask you about the product growth. The product growth is going from 42% to 15%, if my math is right, from last year to next year to this year. And on the other hand, your commentary is positive.

Speaker 10

There's more activity. There's more product sales. So can you take us through the dynamics of product growth, and also the Connection, the relationship between services and products. Thanks.

Speaker 3

Yes, I'll start with the last one first, if you will. I think that Yes, I think we are very excited about the opportunities in front of us in terms of how the company is executing. But we are certainly also very cognizant of the unknown of the macro environment. And I think there's just an here in terms of how we guide for the full year to really bake in concerns around the macro and how it may manifest in the coming months, Coming quarter. So I think you're seeing that and I kind of made a comment earlier that historically it's been tough for me to be somewhat cautious on service revenue because Visible, we're looking at short term deferred revenue and the conservatism oftentimes ends up in product revenue.

Speaker 3

I think there's still an element of that in this conversation.

Speaker 2

Yes. I think for the backlog, like what I said in last quarter, it's Continue shifting towards the network area, network in the WiFi, which is more industry standard product. I'd say probably today most of the backlogs also come from the network side and the Wi Fi side, which has a higher cancellation rate. And So that's where we like Keith mentioned, we take a pretty when it's partly conservative, but that's definitely pretty Good estimate, what will be impact of the whole year on all this the backlog for the product revenue? And the product revenue definitely we see probably going forward the benefit of the new And also some of the new products that will help him and also some of the case that the use case, additional use case Of the firewall, definitely also helping, but it will take some time.

Speaker 2

So that's why we tend to be very careful To forecast at the same time, we do see long term, we still have a huge advantage compared to other competitors Because the investment we made in the product, in the hardware, in ASIC, give us huge advantage of the total cost ownership. So We'll continue to keep gaining market share in that space.

Speaker 10

And do you provide some numbers about the backlog or maybe how Teriall it is to revenues

Speaker 3

as a percentage of revenues?

Speaker 2

I think it seems it's been a very difficult to forecast at the same time With the change in cancellation and also most of the backlog related to the networking Wi Fi, Wi Fi is not a core product. So that's where since last quarter we no longer provided the detail of the backlog. We feel that that could be a little bit misleading if we keep in providing that.

Speaker 3

I think we can offer you some directional comments. So the headlines would be that backlog was up year over year. Quarter over quarter, it was down. But as you start thinking through how to treat the backlog in terms of doing your own models going forward, again, we would come back and remind you of a couple of things. We expect the cancellation rates are going to increase and that's baked into our guidance as we look at things.

Speaker 3

And when we say return to historical norms in Commentary, I think we probably would have 3 years ago had backlog for professional services and training that may have been in the $30,000,000 range. So maybe with growth now, you're probably looking at a steady state that could get you over $40,000,000 to $50,000,000 So just a note of caution, they'll just take all that backlog and it's all going to convert into billings and revenue in 2023 given those dynamics. Got it. Thank you.

Speaker 2

Uh-huh.

Operator

Thank you. One moment please. Our next question comes from the line of Ittai Kidron of Oppenheimer. Your line is open.

Speaker 2

Thanks. Hey, guys. Nice quarter. Keith, I was wondering if you could do a little bit of a deeper dive for us into the enhanced Part of your business, if there's a way for you to kind of break it down a little bit for us by product and perhaps rank order for us Categories which are growing above the average for the category and below the average for the category, we'd just like to get a little bit more color As to the change in mix within that?

Speaker 3

Yes. I don't know that I've really seen a change in the mix, if you will. I think When you look at the manage what we call the 40 management, 40 analyzer, and certainly the virtual machines are doing very, very well. And then as you start looking at the tail of the fabric products in the areas of EBR and monitor and SIM and so on and so forth, I think that they're smaller dollar totals, but sometimes very dramatic and exciting growth rates. So I want to be a little bit careful about getting Painting anybody in too great a light in terms of their contribution because everybody is contributing.

Speaker 3

Certainly, the networking equipment part of the business This has done very, very well and this is a key component of this convergence story that we've talked about and it remains probably about a third of the fabric business.

Speaker 2

Got it. Excellent. And then just going back to the cancellation rate, just to make sure I understand this. How much of this is tied into supply chain, meaning if supply chain isn't getting better, availability is no longer an issue, Customers are less perhaps interested in getting too far ahead in line in waiting for product. How much of that is a factor in this?

Speaker 2

The supply chain environment definitely has some For networking for the WiFi, that's where sometimes certain customers, they may have a multiple order to see which vendor can deliver Because a lot of networking equipment, Wi Fi is a pretty standard product. Even for us, we do add quite some security functions in there. But it's sometimes customer just cannot wait. So that's where we see a little bit higher cancellation rate With I think it's right now the overall supply chain environment, I think, has been improving.

Speaker 11

Yes, I

Speaker 3

think again, The conversation around cancellation rates, a few things there. We said it went from mid single digits to high single digits. And then as we've built into the guidance, It is a multiple that we've built into the guidance of what we just saw in the Q4. What we actually get out of it, we'll see. But the reason to be so cautious about it is what Ken is talking about.

Speaker 3

Yes. We knew that we had an advantage with firewalls and dealing with our suppliers and our vendors and we thought we'd be successful in pushing down that component of backlog first. And indeed, the mix has shown that. I think it's now something on the order of about 75%, 75%, 25% between Networking equipment and firewalls, still firewalls in the mix. But as Ken is pointing out is there may be more risk with that network Equipment of cancellations as we go forward and particularly as the backlog for those elements continue to age out a little bit As we move through this process.

Speaker 3

In terms of continuing supply chain challenges, not quite sure I was making the length on that. I don't Yes, I guess that would have an impact on the continuing build of backlog. But as we said in our comments, we really expect to get to a backlog number By the end of this year, that's much closer much more closely aligned with our historical norms.

Speaker 2

Very good. Thanks. Good luck.

Operator

Thank you. One moment please. Our next question comes from the line of Andrew Nowinski of Wells Fargo. Your line is open.

Speaker 12

Okay. Thank you. Just two quick questions. First, I want to ask A question on EMEA. You've had 5 quarters now of accelerating growth in Europe and that seems to defy the macro trends that we Consistently hear about in Europe.

Speaker 12

Just wondering if there's something specific in your portfolio that might be driving that strong growth in Europe?

Speaker 2

We definitely have a pretty long tenure and good team there. And at the same time, The case, the firewall case also expand quite well in Europe in some countries there. And Some of the service provider carrier, they are a little bit more ahead compared to some bigger service Provider about the U. S. Are moving some new solutions, including some 5 gs SD WAN.

Speaker 2

So that's where we continue to see some good growth there. Also, we kind of surprisingly, even during the recession, the SMB sector growing quite strong compared to some enterprise. Enterprise more about how to lower the cost ownership, protect some of their own kind of profit margin. But SMB, they do see the importance of cybersecurity, especially in the ransomware. They are starting more target SMB right now.

Speaker 2

So we do see quite strong growth in SMB and so that's also helping some regions in Europe.

Speaker 12

Got it. Okay. And then I wanted to ask about gross margin. So you talked about easing cost pressures and lower discounting as some of the levers that drove that better than expected gross margin. I guess, number 1, how sustainable do you think those factors are as we look into fiscal 2023?

Speaker 12

And then when you launch new ASIC like you did Early today. Is that a headwind to gross margin initially?

Speaker 3

Yes. I think the good thing we talked about price benefits, the discounting and then some easing of the impact of supply chain. Yes. I think the price benefit is something that will obviously stay with us in the future. And so we should still get a tailwind from that.

Speaker 3

However, Discounting and supply chains, call it savings for lack of a better term, that's really related to Our history of price increases. And I think we kind of reached a very kind of maybe the high watermark in terms of being Having price increases covering those costs and that will start to settle back down to a more normalized pattern going forward, meaning that we'll still have inflationary Cost increases, but we've really slowed down the price benefits the price increases. So net net, price increases continue, discounting and supply chain benefits may not.

Speaker 12

Okay. Got it. Thank you.

Operator

Thank you. One moment please. Our next question comes from the line of Ray McDowell of Guggenheim Partners. Your line is open.

Speaker 11

Hi, thanks. Maybe for Ken or Keith. The last time we saw product growth accelerate for 2 years Was back in 2014 and 2015, you had 2 really strong years of product growth and that was followed by a pretty sharp deceleration of growth over the next 2 years. And I understand the business is a lot different than it was back then, but there does seem to be some similarities at least how it relates to the macro environment and your results obviously point to You guys navigating it, the macro quite well, but you did reiterate your 2025 guidance, which I believe implies mid teens product growth. So I guess the question is why should we think this time is different?

Speaker 11

Is it just that you have a significantly larger portfolio of solutions? Is it Broader acceptance from customers willing to consolidate networking and security functionality. Any comparisons or contrast you can provide specifically as it relates to product Growth versus, if you will, the previous cycle would be helpful.

Speaker 2

I think in the 2014, 2015, that's The outbreak of a larger target of Sony case, which allowed enterprise to upgrade from the traditional Connection based firewall to the next gen firewall, which including some including provisions and other things. So that's where it's more like kind of refresh, more in the enterprise area. So we do see some strong growth there after this several issue. And then but this time, we see there's a few things. 1 is really during the pandemic, there's a new infrastructure need to build, supporting work for home, work for anywhere.

Speaker 2

At the same time, the ransomware attack quite broadly hit the whole industry. And other part, we keep in seeing the convergence, which is like D WAN, the 5 gs, the WiFi and also internal segmentation. So that's a much broader use case Of the firewall deployment, also including a lot of more device being connected. So we feel this time is very kind of a more broad firewall use case cannot apply to the whole infrastructure. That's what we kind of more emphasized.

Speaker 2

The convergence It's a little bit different than the last time, like 8, 9 years ago. So that's why we feel this time probably will be most Smooth transition, because the traditional firewall, whatever, will not go away. And at the same time, there's a more use case Hi. Convergence into the traditional networking area, expanding to the OTs and other area, we're helping driving the product revenue growth and then followed by the additional service revenue. So that's the sense we're planning.

Speaker 11

Thanks. That's helpful. And if I could, maybe a follow-up. You talked a little bit about the momentum in large deals and enterprise deals in 2020 But given the macro environment, could you compare and contrast, maybe Keith or Ken, the behavior you're seeing from larger customers and maybe those On the smaller end of the spectrum, are you seeing more deal delays up market, more propensity to consolidate functionality at the lower end. Anything any more color would be helpful.

Speaker 2

Yes. It's definitely helping the customer lower the total cost Both on the management cost and also on the product service cost, which we have huge advantage over the competitors. So that's where we see a lot of big enterprise customer. They definitely want to when they see the renewal, when they see all these Need to add additional protection for the infrastructure. They do see this like how to have a better total cost ownership and at the same time Leverage single integrated platform, automated platform to offer better security networking together.

Speaker 2

Even there's a trend to merge The traditional network operating team and security team together, so making the SOC and NOC kind of combine together and also Converge of the traditional networking and security together. So we do see some trend happening in the big enterprise and which we Kind of develop technology and the long term investments starting to see, I mean, a steady benefit for further trends.

Speaker 3

Great. Yes, go ahead. Like everybody else, I mean, you're reading about people talking about It's taking longer to get across the finish line and more approvals and so forth. And I don't think we are immune to that by any stretch of the imagination. Keep in mind as we're going through The world's moving through this.

Speaker 3

At the same time, Fortinet's kind of expanding from just 7 figure deals. And I think we talked about 546 7 figure deals or more last year, if I remember correctly, a huge number. And now adding more and more 8 figure deals. So I think we're probably seeing Yes. Huge opportunities, but we're also getting exposed to how that approval process works and how we manage with our sales team, our customers through that process.

Speaker 11

Great. Thanks for the color and congrats on the strong results.

Operator

Thank you. One moment, please. Our next question comes from the line of Adam Tindle of Raymond James. Your line is open.

Speaker 13

Okay. Thanks. Good afternoon. Keith, I wanted to start with Pricing, I think we picked up, if we got this right, another pricing increase announced in January, effective in February. Wondering if You touched on the rationale and early response to that.

Speaker 13

Where are we in elasticity of demand? And thinking forward, obviously, Costs are ultimately going to normalize hopefully in your model. What would be the strategy for you once costs normalize? Would you reduce price or capture margin? Thanks.

Speaker 3

Yes, the last part first. I mean, I think we'll continue to monitor the market and make appropriate adjustments there. I don't Yes. Seeing inflation go backwards is probably not something that's happened a lot in history, but it could happen, I guess. In terms of the most recent price increase that we talked about, it's almost a non event to me.

Speaker 3

It's extremely low single digits gross and after discounting, it's a fraction of an interest point.

Speaker 13

Got it. Okay. And then maybe just as a follow-up for Ken. I wanted to ask on Sassy competition. 1 of your main competitors has Said they've integrated their SaaS offering with SD WAN and Secure Web Gateway in particular.

Speaker 13

They're pushing that sales motion across the entire sales force now. As we think about Fortinet, obviously very strong in SD WAN, but that Secure Web Gateway or proxy piece is perhaps not as prevalent or a different strategy. It's clearly not impacting your unit market share at present, but just thinking forward to competing and differentiating in Sassy now that your competitors Really pushing that motion across the entire sales force. Thank you.

Speaker 2

Yes. I think we our strategy, like I've taken say in the last few years is, First, we want to have a SASE or integrate in the same system, the same OS, including our SD WAN or the SASE function. So making SASE can be more easily broadly deployed and also working with service provider to leverage their infrastructure To offer the Sassy, so it's a little bit different than some of the Sassy player right now in the market. So we do believe this is highly integrated The single system OS will be more efficient and at the same time will be more secure. And So that's why we're keeping building and what are the new 40 ASIC chip SP5 and also the new 40OS I will flag all this kind of development we're reporting into the solution.

Speaker 2

At the same time, we keep working closely with pretty much all the carrier service provider, even cloud provider to offer SaaS together. And that's also a little bit different strategy compared to some other SaaS players. So we do believe long term leverage infrastructure, a lot of service provider, I tell the call provided ahead, we'll be much more efficient than the profit model compared to some of the Sassy A solution player kind of keeping losing money, which will be difficult to last long. So that's why we will keep investing in this area and also we want to be a long And also we'll be keeping internal innovation R and D And keeping driving this space.

Speaker 13

Very helpful. Thanks and congrats on the year.

Speaker 2

Thank you. Thank

Operator

you. One moment please. Our next question comes from the line of Ben Bollin of Cleveland Research. Your line is open.

Speaker 14

Good afternoon. Thanks for taking the question. Could you share a little bit of what is happening With respect to the cloud infrastructure build out, tell us a little bit about what you're doing, where you are in the progress and Customer response thus far? And then I had a follow-up in the networking category.

Speaker 2

Yes, we continue keeping building out the infrastructure, including the cloud. Also, our strategy is a little bit different than some other Hi. We tend to build out ourselves just like we you can see the investment in some of the real estate, A question, I'll also go to the like a data center infrastructure. That's give us much better cost and also More long term benefit, just like how we the investment made in early real estate kind of benefit our office cost, rental cost. So that's where we're using the cost saving we get from this rental, keeping invest into some more long term infrastructure, Real estate, we do see that's what keeping benefit of the company long term.

Speaker 2

But at the same time, like I said, also partner working with carrier service Provided that's other strategy we have, leverage some of their infrastructure. So that's also make a win win. Both Paddy, will benefit, will be profit. That's also the strategy we have.

Speaker 14

And within that, Ken, could you speak to, is this Is it purely cost? Is latency part of the narrative? Is it being closer to your customers? What's the broader strategy within it?

Speaker 2

Not just but also we'll make it easy to manage, easy to scale. Even some of the SaaS solution, I do believe some bigger customers, they may even do themselves. So if you can integrate a more SaaS function into the same OS, into the same system, So that's the long term strategy we have. And also working with service providers is very, very important for us.

Speaker 14

Okay. And then my last one, Ken, what are your thoughts on the traditional campus networking opportunities, the WLAN market? How do you think about wallet share opportunity and the ability to displace more of the incumbent there? That's it for me. Thank you.

Speaker 2

That's kind of the thinking we have like over 20, 30 years, right? There's a convergence The networking and network and network security, I think SD WAN is a very good example. So the secure SD WAN solution will be More efficient, more secure, and there's a lot of additional service we can apply in secure SD WAN, which is We had to offer for free, we are not kind of there yet, but same thing for a lot of other one technology. And so we That's a huge potential. And but also doing security in the networking environment not need Huge company power, which has come from ASIC investment we made, which also will take a long time to see the return of investment.

Speaker 2

That's where we kind of committed from day 1, back 23 years ago. So when we start, we really need to We invest and planning all these kind of long term convergence of network and network security together. So The new AC chip is one example. It's the 5th generation of SoC chip, which also including some of the investment we made in the 9th generation of our Content processor and the 7th generation network processor together with a lot of multi core CPU. So we'll continue to develop Technology and eventually will be deployed more broadly beyond the traditional network security.

Operator

Thank you. I'd like to turn the call back over to Peter Stalkowski for any closing remarks.

Speaker 1

Thank you, Valerie. I'd like to thank everyone for joining today's call. Fortinet will be attending investor conferences hosted by Baird and Morgan Stanley during the Q1. A Webcast link will be posted on the Events and Presentations section of Fortinet's Investor Relations website for the Morgan Stanley Conference. If you have any follow-up questions, please feel free to contact Have a great rest of your day.

Speaker 1

Thank you.

Operator

Thank you. Ladies and gentlemen, this does conclude today's conference. Thank you all for participating. You may now disconnect. Have a great day.

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