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Fortinet Q1 2023 Earnings Call Transcript


Listen to Conference Call

Participants

Corporate Executives

  • Peter Salkowski
    Vice President, Investor Relations -Fortinet, Inc
  • Ken Xie
    Founder, Chairman of the Board and Chief Executive Officer
  • Keith Jensen
    Chief Financial Officer

Presentation

Operator

Good day, and thank you for standing by. Welcome to the Fortinet's First Quarter 2023 Earnings Announcement Conference Call. At this time, all participants are in a listen-only mode. After the speakers' presentation, there'll be a question-and-answer session. [Operator Instructions] Please be advised that today's conference is being recorded. I would now like to hand the conference over to Peter Salkowski. Go ahead.

Peter Salkowski
Vice President, Investor Relations -Fortinet, Inc at Fortinet

Thank you, Chris. 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 first quarter of 2023. Speakers on today's call are Ken Xie, 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 the call today by providing a high-level perspective on our business. Keith will then review our financial and operating results for the first quarter of 2023, before providing guidance for the second quarter of 2023 and updating the full year. We'll then open the call for questions. During the Q&A session, we do ask that you please limit yourself to one question and one follow-up question to allow others to participate.

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 in 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, all references to financial metrics that we make today are non-GAAP, unless stated otherwise. Our GAAP results and GAAP to non-GAAP reconciliations are located in the earnings press release and in the presentation that accompanies today's remarks, both of which are posted on the Investor Relations website. 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 today's call. Lastly, all references to growth are on a year-over-year basis, unless noted otherwise. I'll now turn the call over to Ken.

Ken Xie
Founder, Chairman of the Board and Chief Executive Officer at Fortinet

Thanks, Peter, and thank you to everyone for joining today's call to review our outstanding first quarter 2022 result. For the first quarter, revenue growth was 32% due to strong growth in both product and service revenue with 35% product revenue growth, we continue to gain market share, while being a leading product revenue company in the cybersecurity industry. This strong product revenue growth will help drive future service revenue growth. Quarterly service revenue grew over 30% for the first time in six years. We believe, we have a significant opportunity to upsell value-added secured service to a large installed base. In the first quarter, SD-WAN and OT bookings together continued to account for over 25% of total bookings and our goal is to become the number one in network firewall, secure SD-WAN and OT security market over the next couple of years. Fortinet is leading the trend of network and security convergence and cybersecurity consolidation. Gartner expects that by the year 2030, the secure networking market will be larger than traditional networking. Traditional networking lacks awareness and control of content, applications, users, device and location and is still using the same network protocol that was developed 50 years ago. Fortinet secure networking solution has expanded from next-gen firewall to SD-WAN, SD-Branch, 5G, Internal Segmentation, ZTNA and Universal SASE. And we believe, the secure networking market can achieve double-digit growth annually for the foreseeable future.

In today's environment, organization are looking to consolidate their multiple security vendors and functions that are deployed across the expanding attack service to lower their total cost of ownership and management costs, while improving visibility and automating new time threat detection and response. Fortinet latest release of FortiOS 7.4 together with the FortiSP5 ASIC leads the industry in better integration and automation, as well as a faster acceleration while lower total cost ownership. FortiOS enable automation to deploy the Fortinet Security Fabric to every edge, allowing security to dynamically scale and adopt as network evolves. Last month, we announced Universal SASE, which is supporting hybrid infrastructure and enable the same networking and security features that are available in our plans to be delivered as a service, all within a single console. Many of our service provider partners are collaborating with us on these offerings. Also, we announced an enhancement to several of our Fortinet Security Fabric solutions including endpoint security, cloud security, SoC and SOAR. As networking and security continue to converge and customers looking to consolidate vendors and point product, we believe we are well-positioned to achieve our 2025 building target of $10 billion, while generating an annual non-GAAP operating margin of at least 25% for each of the next three years. Before turning the call over to Keith, I would like to thank our employees, customers, partners, suppliers worldwide for their continued support and hard work. Keith?

Keith Jensen
Chief Financial Officer at Fortinet

Thank you, Ken, and good afternoon, everyone. Let's start with the key highlights from our strong first quarter performance. Our strong first quarter results reflect continued demand for our broad portfolio of cybersecurity and networking solutions and the demand for consolidation and convergence that is delivered by our integrated single-platform strategy. Total revenue growth of 32% was led by strong product revenue growth and service revenue growth accelerating to over 30%. Billings increased 30%, our eighth consecutive quarter of at least 30% billings growth. Secure SD-WAN and OT bookings once again accounted for over 25% of total bookings. Our strong topline results reflect continued customer demand across both, core and enhanced platform technologies and highlights the diversification of our business model by; solutions, geographies, customer segments and industry verticals. We continue to deliver balanced growth and profitability with better than industry average topline growth and strong profitability despite the continued economic uncertainty.

The first quarter operating margin of 26.5%, represents the highest first quarter operating margin in our 14-year history as a publicly traded company. Free cash flow of $647 million, representing a margin of 51% is up 23 percentage points. Both the quarterly free cash flow and free cash flow margin are Fortinet post, IPO records. Last month, we hosted nearly 3,000 customers and partners of our very successful Accelerate conference, I'd like to recap three key themes; one, the expanding firewall deployment environment; two, convergence and three, consolidation. So starting for us today's rapidly evolving threat landscape and connectivity demands a comprehensive approach to firewalls and network security, including a combination of hardware, virtualized software and security services. In fact, Gartner anticipates that by 2026, more than 60% of organizations will have more than one type of firewall deployment, which will prompt adoption of hybrid mesh firewalls. Fortinet is well positioned to capitalize on this expansion of firewall deployments and form factors, as we've been delivering hybrid mesh firewalls for years on a single operating system.

Second, the company was founded 20 years ago on the belief that the convergence of security and networking will become an industry standard. Gartner shares this belief, noting they expect the size of secured networking market to overtake the traditional networking market by 2030. We believe secured networking at scale, works most effectively on ASIC technology. Since its inception, Fortinet has been developing proprietary ASIC technologies to build application-specific solutions to support convergence that traditional CPU-based solutions are less efficient, as supporting both networking and security. Third, vendor and product functionality consolidation strategies continue to become more commonplace. Looking to Gartner here again, they notedg 75% of organizations are pursuing a cybersecurity vendor consolidation strategy in 2022, up from 29% in 2020. Our integrated FortiOS platform allows customers to converge networking functionality with security capabilities, while consolidating cybersecurity products and functionality, with FortiASIC significant computing power advantage, FortiOS can consolidate more security functions and solutions, while maintaining our performance and cost advantage. Specifically, FortiOS supports many security applications including network firewall, SD-WAN, SASE, 5G, WiFi security, ZTNA, VPN and SSL, with a variety of use cases for each security application. For example, firewall use cases include data center, branches, edges, virtual, cloud native, micro segmentation, both east-west and north-south and Firewall-as-a-Service. Our convergence and consolidation strategy provides security across our customers' entire digital infrastructure, while lowering their operating costs.

Now let's take a closer look at the first quarter. Buildings grew 30% to $1.5 billion, driven by enhanced platform technology solutions. In terms of industry verticals, government and financial services topped the list as a percentage of total billings, with financial services up over 40%. Construction, media and utilities were all up at least 50%. Those growth benefited from better-than-expected backlog contribution. While the backlog cancellation rate increased quarter-over-quarter, it was lower than we had forecasted in our model. We continue to believe there's an elevated cancellation risk in future periods for networking equipment backlog.

Bookings grew double digits in the quarter, off a challenging comparison to 50% growth in the first quarter of last year. We continue to see success with our strategy to expand further into the large enterprise segment with a number of deals over $1 million, increasing 38% to 124 deals and billings on these deals increasing 50%. One of these deals was an eight-figure expansion and upsell opportunity at a Fortune 50 retailer. The retailer was looking to replace their firewall point solutions with a more holistic cybersecurity solution.

After purchasing FortiManager and FortiAnalyzer in the fourth quarter of last year, this customer selected FortiGate VMs for a very competitive very competitive process for their 2,000 store locations as part of our new FortiFlex program. FortiFlex is a new point-based consumption program supporting hybrid mesh firewall deployments as well as a variety of other security solutions. The customer selected for a net due to the substantial value offered by our unified platform, and the significant technical requirements. In the first quarter, we added approximately 6,100 new logos, reflecting the support of our channel partners to their investments and the investments we've made in them. Average contract term was flat year-over-year at 27 months and down one month quarter-over-quarter.

Turning now to revenue. Total revenue grew 32% to 1.26 billion driven by strong demand for core and enhanced platform technologies, increasing 23% and 50%, respectively. Product revenue of 501 million increased 35% despite the very difficult comparison to last year's first quarter at 54%, with its very strong contribution from acquisitions. Product revenue growth was driven by strong growth in enhanced platform technologies, improving supply chain dynamics and our earlier pricing actions. Service revenue was up over 30% to 762 million, the highest growth rate in services since 2016. The average number of days between when the customer purchases and subsequently activates a security service contract declined slightly sequentially and remain elevated on a year-over-year basis. Service revenue growth was closely aligned with our short-term deferred revenue growth rate in recent periods. Short-term deferred revenue growth was over 30% for the fourth consecutive quarter.

Total gross margin of 76.3% was up 190 basis points, including a 440 basis point increase in product gross margin to 61.8%. Product gross margin benefited from earlier pricing actions, improved discounting and easing cost pressures. Service gross margin of 85.9% picked up 70 basis points as price increases offset increased investments in data centers and points-of-presence or PoPs. Operating margin of 26.5% was up 450 basis points due to the strong gross margin performance of foreign exchange benefit and revenue growth that was 10 points higher than our 22% headcount growth. As previously noted, 26.5% is our highest ever first quarter operating margin as a public company.

Looking at the statement of cash flow summarized on slide seven and eight. Free cash flow was a quarterly Fortinet record at 647 million and benefited from elevated receivables in the fourth quarter of last year in the subsequent cash collections as well as the record-setting operating margin and the timing of capex projects. Adjusted free cash flow, which includes the real estate investments, was 662 million, representing a 52% adjusted free cash margin and our highest margin since our 2009 IPO. We've come to expect some quarterly variances in our free cash flow results with the first quarter often stronger due to the seasonally strong fourth quarter billings. Capital expenditures were $30 million, including 15 million of real estate investments. This was lower than expected due to the timing of real estate activities.

Cash taxes were $21 million. The Board increased the company's share repurchase authorization by 1 billion and the total available share buyback authorization is now 1.5 billion for repurchases through February 2024. Looking forward, we are excited about the growth drivers that we've discussed previously as well as our new single vendor, universal SASE offering. Our universal SASE offering delivers a comprehensive solution that extends the convergence of networking and security from the edge to remote users, while helping teams drive operational efficiency and reducing complexity and costs by consolidating vendors. In fact Gartner predicts that by 2025, one-third of new SASE deployments will be based on a single vendor SASE offering, up from 10% in 2022. As we bring universal SASE to market, we expect to make various investments, including increasing our PoPs.

Our guidance reflects the impact of these investments to both our gross margin and capital expenditure estimates. Moving to guidance. I'd like to review our outlook for the second quarter and full year summarized on slides 10 and 11, which is subject to the disclaimers regarding forward-looking information that Peter provided at the beginning of the call. For the second quarter, we expect billings in the range of 1.560 billion to 1.600 billion, which at the midpoint represents growth of 21%. Revenue in the range of 1.280 billion to 1.320 billion, which at the midpoint represents growth of 26%. Non-GAAP gross margin of 75.5% to 76.5%. Non-GAAP operating margin of 24.5% to 25.5%, non-GAAP earnings per share of $0.33 to $0.35, which assumes a share count of between 790 million and 800 million.

Capital expenditures of 80 million to 110 million; a non-GAAP tax rate of 17%. Cash taxes of 35 million, which is lower than our prior expectation as the deadline for certain tax payments has been extended to the fourth quarter. The second quarter guidance assumes backlog decreases during the quarter. For the full year, we expect billings in the range of 6.75 billion to 6.810 billion, which at the midpoint represents growth of 21%. This guidance assumes a low single-digit impact of billings growth from backlog.

Revenue in the range of 5.425 billion to 5.485 billion, which at the midpoint represents growth of 23.5%. Service revenue in the range of 3.370 billion to 3.400 billion, which at the midpoint represents growth of 28%. The service revenue guidance implies product revenue growth of 16%. Non-GAAP gross margin is 75% to 76%. Non-GAAP operating margin of 25% to 26%, non-GAAP earnings per share of $1.44 to $1.48, which assumes a share count of between 795 million and 805 million. Capital expenditures of 400 million to 450 million, due to the continued cloud, data center and facilities investments.

Non-GAAP tax rate of 17%, cash taxes of 390 million, with approximately 300 million in the fourth quarter. The full year estimates assume backlog returns to historical levels later this year. As we wrapped up the prepared remarks, maybe one additional observation. Over many years, the Fortinet team and its partners has offered very solid and consistent level execution across a wide range of economic cycles and other challenges. Like many others, we see a level of economic uncertainty in front of us and we look forward to this possible challenge in delivering on our goals.

I'll now hand the call back over to Peter to begin the Q&A.

Peter Salkowski
Vice President, Investor Relations -Fortinet, Inc at Fortinet

Thank you. As a reminder, during the Q&A session, we ask that you please limit yourself to one question and one follow-up question to allow others to participate. Chris, please open the call for questions.


Questions and Answers

Operator

Our first question comes from Brian Essex from J.P. Morgan. Your line is open.

Brian Essex from
Analyst at J.P. Morgan

Hi, good afternoon, and thank you for taking the question, and congrats on a nice quarter, particularly in a tough macro. Maybe, Keith, for you. Nice acceleration in services revenue this quarter. And I know Ken talked about more effectively is selling or some value-added services -- secure services into your installed base, how much was due to that better attach rate of secure services versus changes in registration policy or pricing increases in the quarter?

Keith Jensen
Chief Financial Officer at Fortinet

Yes. When we -- great question, Brian. And I think when we peel the onion back there, we saw in FortiGuard, which was the security services part of the business. And you'll see this in our SEC filings next week. Growth was 35% for FortiGuards. So we started looking more deeply at that. And to Ken's point, what we saw there were areas like SaaS products and offerings that are attached to existing customers, certain cloud offerings, what we call pay as you go, if you will, were attached to it as well. And I would describe those as being a significant driver to the growth. I think the price benefits will probably take the number two slot. And then the number three slot would be some changes in the registration behavior. By that, I mean, customers did register a little bit faster in the first quarter. But that lag -- that registration policy change that we implemented in the first quarter that was a specific call out is not really having an impact in the first quarter, nor did we really expect one. So kind of in order, I think it was selling into the installed base, price increases and then some wide improvements in the registration behavior.

Ken Xie
Founder, Chairman of the Board and Chief Executive Officer at Fortinet

Yeah. Also with the new FortiOS 7.4, we started launching -- we started to have a more function, which can also enable much more new service going forward for both the current customer installation base and also for new customers.

Brian Essex from
Analyst at J.P. Morgan

Got it. That's helpful. And maybe as a follow-up, Keith, I think you commented on lower than expected cancellation rate. I know the question will be asked, impact on billings from backlog train? And what some of your assumptions are, particularly given what you see in macro? I know you talked about, you expect to be at normalized rates for backlog by the end of the year, but maybe if you can contextualize or quantify that to the extent that you're able to?

Keith Jensen
Chief Financial Officer at Fortinet

Yeah. I think in the guidance, particularly as we look at the full year, it's difficult to figure out exactly what quarter some of that backlog is going to end up in or be canceled. But for the full year, I think we talked about low single-digit growth that would be coming from the backlog. I do think that the risk of cancellations increases as the year progresses. So by that, I mean, if the customer has only been in backlog for a week or a month or something like that, they're seeing somewhat less probability that they're going to cancel. But the longer it takes to deliver on that backlog, I think the cancellation risk continues to increase.

Ken Xie
Founder, Chairman of the Board and Chief Executive Officer at Fortinet

Also point is really, you mentioned go by normal end of the year, we see later this year, it could be middle, it could be towards the end. But in Q1, I say, the operations team did a great job to reduce the backlog, which also helping secure more customers and lower some cancellation rate.

Brian Essex from
Analyst at J.P. Morgan

Got it. Very helpful. Thank you both very much.

Operator

Thank you. One moment for the next question. This question comes from the line of Gabriela Borges with Goldman Sachs. Your line is open.

Gabriela Borges
Analyst at The Goldman Sachs Group

Good afternoon. Thank you. I have for Ken or Keith. It's a follow-up question on for costing, which is we've heard so much noise in the industry around supply chain and cover catalyst product cycles. How do you all think about true demand and potentially plan around the risk of demand going faster than expected, given you've had a very strong couple of years? Thank you.

Ken Xie
Founder, Chairman of the Board and Chief Executive Officer at Fortinet

I think probably, some of that more refer to the traditional network security, secure some deployment enterprise. But we do see that our solution has a much broader use case. And also expand to much bigger market opportunities in the traditional enterprise firewall and also the SD-WAN OT, it's also see strong growth continue to helping drive both the new customers and also expanding the current existing customer. Also in the SMB space, it's relatively greenfield. We also see pretty healthy, faster growth, probably even faster than the traditional enterprise, which is more replacement. I think all this actually contributing to a pretty healthy keeping saying double-digit growth in the future for the wholesale network security space.

Gabriela Borges
Analyst at The Goldman Sachs Group

Yes. That makes sense. Thank you. And Ken, the follow-up is for you, which is as we start to execute more on the convergence of selling into the networking budget or the convergence of networking plus security, when you look at the classic networking competitors, how do you think about the barrier of the limitation for classic networking vendors to get more into security and become more competitive in the convergence over time.

Ken Xie
Founder, Chairman of the Board and Chief Executive Officer at Fortinet

I have to say from the product architecture, it's very different because security needs much more complete power and to handle a lot of unstructured data, which the traditional networking company, probably more based on some structured data, handle some fixed network protocol, and much less computing power needed to process data compared to the network security. So that's where -- and also, we would have to implement function and the new function come up every year in the software first and then keeping enhancing improving performance, leverage ASIC, that's also we don't see networking company doing some of that. They probably may be slow on where to come up a new function for the security space, all kind of have a different architecture to really supporting the secure computing needed for network security. So that's -- so far, we have not seen the traditional networking company really come close. They did some acquisition, but so far, I don't see the really come up too much since to meet new demand from customers, both on the function and also on the service on the infrastructure change.

Gabriela Borges
Analyst at The Goldman Sachs Group

Thanks for the details. Congrats for the quarter.

Ken Xie
Founder, Chairman of the Board and Chief Executive Officer at Fortinet

Thank you.

Operator

Thank you. One moment for the next question. The next question comes from the line of Fatima Boolani of Citi. Your line is open.

Fatima Boolani
Analyst at Smith Barney Citigroup

Thank you. Good afternoon. Appreciate taking my questions. Ken, just a technology vision question for you. You are very -- and the team is very bullish on the SASE opportunity that was very apparent at the Accelerate conference as well. But I'm curious as to why you're taking the effort to build out data centers and points of presence to deliver your Universal SASE strategy versus maybe some of your peers and competitors who are maybe relying on third-party providers hyperscalers? And then I have a quick follow-up for Keith, please.

Ken Xie
Founder, Chairman of the Board and Chief Executive Officer at Fortinet

First of all, SASE, kind of is a little bit different than some of our competitors. We do believe it will be a universal need to be more broadly deployed and also more leverage a lot of service provider infrastructure is kind of a hybrid environment instead of a cloud-only SASE solution. And we do keep expanding some of our part because there's -- definitely, there's some user like whether depending on work from home or some other cloud -- SASE to secure some of their traffic here. But on the other side, there's a huge base of customer need to use SASE or kind of service model, evitable service provider all their current infrastructure and even on-site appliance. And so that's where a certain point, we also see our FortiSwitch and FortiAPs kind of hardware agent helping for the traffic for the FortiGate to process all these SASE traffic there. So that's where -- that's the reason we kind of put that in a single OS, both on the networking side function like SD-WAN, 5G or other past security like a CASB, DLP, all these firewall service all these things. So that's where we have a more integrated, more broadly distributed and leverage whatever the hybrid infrastructure SASE solution there. That's also the reason we continue to build some of the PoP. It's a little bit different than some other very certain cloud providers because we do see the care provider potentially also can be the service provider to offer SASE. And also from the high point of view, even have a little bit more investment from the beginning to build some PoP ourselves. But long time will be more profit model. So we have a better margin -- so it will take some time to make sure we build a healthy ecosystem, both with our partner and also its investment for long-term benefit.

Fatima Boolani
Analyst at Smith Barney Citigroup

I appreciate that detail, Ken. Keith, just quickly for you, kind of a tactical question on the billings outlook. You're raising the full year by less than half the beat and raise when I think about the first half. And so maybe from a bottom-up perspective, can you walk us through what sort of underpinning that conservatism. I can appreciate the macro is jittery, but if you can kind of give us some more tangible considerations or thinking about in terms of a bottom-up perspective on getting to that billings guide for the full year? Thank you.

Keith Jensen
Chief Financial Officer at Fortinet

Yes. I would say, one just kind of as a general thought, I think raising it to some extent, I think, probably gives you a little bit about of a message that we feel good about our strategy and the execution that level that we can bring to the market. But more specifically and more tactically, as we look through -- look to the second half of the year, there's probably a little more rigor and effort, if you will, in trying to look at what we see coming in the second half of the year. And I would give you that, probably the two headlines that we're looking at. One is we're still very, very pleased with the pipeline. And the pipeline continues to -- continues to be well above anything that we're talking about growth rates for the company for the full year. But I think the nuance that -- maybe not even a nuance, really, that's coming to play now is more about close rates. It's not just as simple of taking your pipeline, assuming you're going to have close rates that were at the same level they were in prior periods. And that's -- when we use the term close rate, not a suggestion that deals are getting lost, but this continual cycle that we seem to be in, where some of the larger enterprise deals, in particular, are taking longer, they're pushing out a lot of pushes. It's not that there's been an increase in losses, but the continual push. And so, with that in mind, I think a fair amount of attention looking at the full year guidance on what we really think our close rates may be for the second half of this year.

Fatima Boolani
Analyst at Smith Barney Citigroup

Thank you.

Operator

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

Saket Kalia
Analyst at Barclays

Okay. Great. Hey, good afternoon, everyone. Thanks for taking my questions here. Ken, maybe just to start with you, great to see Fortinet sell the whole breadth of the platform, particularly within the enterprise. Could you just maybe talk about anything that you can do to make it easier for customers to consolidate spending with Fortinet, whether that's an enterprise license agreement or any other thing that sort of makes it easier to combine -- consolidate those vendors, which was a theme, I think, was talked about earlier?

Ken Xie
Founder, Chairman of the Board and Chief Executive Officer at Fortinet

We definitely see some healthy growth of enterprise agreement. And also, we're working closely with our channel partner, with our service provider also leverage their connection, their resource to the healthy ecosystem to grow together. But I also see the -- from enterprise level, they also see the benefit of consolidation definitely and also, not just consolidate some of the security product, but also the expanded infrastructure go beyond the traditional network security. So that also we see pretty healthy growth, like in Q1. We do see that we call enhanced -- enhanced technology side also has pretty healthy growth. Yes, the sales force, also you can see the number of $1 million deal, both on the number and also on the dollar-wise, has a pretty healthy growth, continue to accelerate and grow beyond the total building growth. So that's a pretty healthy trend we see going forward to helping customers consolidate.

Keith Jensen
Chief Financial Officer at Fortinet

Yes. And Saket, maybe just -- this is Keith, just to go on a little deeper on what Ken is talking about there, and I'll give you maybe four quick examples. So enterprise agreement is something that we've been doing now for probably a couple of years. We track those as -- in some ways, as a different line of business in terms of the growth rates. And particularly as we move into the enterprise, I think it's been very important to be there, and we've been very successful in it. I think another illustration of trying to make it easier for customers was the example of the large retailer we gave on the call today. And we talked about the points program, right, which is an easier way, I think, sometimes for them to get on board and consume more of the products. And I think also then, when we sell, making sure that our salespeople are well trained on the value proposition that we're offering, not just on the cost of the appliance or the throughput, the performance, but also what it means to the customers' management cost and overhead costs as well. So I think those types of things are all going into play here to support what Ken is talking about, about making it easier for customers to consume our products.

Saket Kalia
Analyst at Barclays

Got it. That's super helpful. Keith, maybe for my follow-up for you. Great to see that 30% growth and acceleration in services revenue. Maybe the question is, how do you think about what portion of your existing subscription base hasn't seen that cumulative impact of the price increases you've done yet, right? Like clearly, the price increases on products have been fully baked. But how much of the base or maybe how long will it take for the subscription base to fully realize that pricing as well?

Keith Jensen
Chief Financial Officer at Fortinet

Yes. Great question, and I think didn't really look at the numbers closely this quarter with the last quarter. A couple of things to keep in mind. The average contract term, call it, 27 months. If all the contracts are 27 months, you can do that math, but they're not some are one and some are three-year contracts -- in terms of the renewals that are coming through. So probably one in five-year contracts. Sorry, Peter, thank you for that. So it does have a long tail. And again, I defer you back to how many quarters or a few years that we talked about seeing the uplift that came when we converted to 24x7 support from 855, that was something that continued to provide a benefit for several years. I think the tail gets smaller, obviously, as you go further out. I think the majority of what's the existing contracts more than 50% are under the new pricing.

Saket Kalia
Analyst at Barclays

Very helpful. Thanks guys.

Operator

Thank you. One moment for the next question. The next question comes from the line of Shaul Eyal of TD Cowen. Your line is open.

Shaul Eyal
Analyst at TD Cowen

Thank you. Good afternoon, congrats on results and guidance in a tough macro. Keith, maybe starting with you. Can you comment -- can you provide us with some color about the financial vertical performance this quarter?

Keith Jensen
Chief Financial Officer at Fortinet

Yes. Well, financial services have always been one of our -- I should say always, but for a long time, even the top three. And it can be a bit feature famine there with some very large deals in the quarter. But I don't think there was anything that was -- it was number two in this particular quarter. Thank you, Peter. I don't think there are any really large deals that drove that number. I think it was -- we saw growth and success, not only in the US but also internationally, particularly in Europe. And so I think it was a strong quarter for us in that area.

Shaul Eyal
Analyst at TD Cowen

Got it. Got it. From a product mix perspective, so the entry level performed the best versus the high-end. Is that just a mix or a macro reflection? And also, did you have any eigth-digit wins this quarter?

Keith Jensen
Chief Financial Officer at Fortinet

So we talked about -- yes, we did.

Shaul Eyal
Analyst at TD Cowen

Okay.

Keith Jensen
Chief Financial Officer at Fortinet

I think we talked about one in the script just a moment ago. I think we commented it was an eight figure deal, if I'm not mistaken, right, without giving a specific number -- yes. And I don't recall if there was a second eight figure deal, there was a second.

Ken Xie
Founder, Chairman of the Board and Chief Executive Officer at Fortinet

Also our SMB had pretty healthy growth. Like I said, SMB is more greenfield for the network security. We do see more-and-more SMB than network security to protect their business, especially comes from some of the resin attacks. On enterprise because it's a kind of more replacement -- and also a lot of enterprise kind of maybe the environment in the refresh some of the hardware more dependent on the service -- so that impacts some of the high end. And also, the other benefit for some of the low and middle range is really -- most -- I'd say most SD-WAN and some of the OT deployment maybe more towards the low and middle range.

Shaul Eyal
Analyst at TD Cowen

Got it. Thank you. Appreciate it. Well done.

Operator

Thank you. One moment for the next question. Next question comes from Rob Owens of Piper Sandler. Your line is open.

Rob Owens
Analyst at Piper Sandler Companies

Thank you very much and good afternoon. Thanks for taking my question. I wanted to start around opex or the quarterly operating margin. A very strong first quarter here. I think you mentioned it was the strongest Q1 that you've had since you're public. If I go back through results since you've been public, Q1 has never really been the high watermark from an operating margin standpoint. So, walk me through your thought process as the rest of this year plays out, was there some aberration in Q1 that really helped drive that or just a lot of conservatism as we look ahead?

Keith Jensen
Chief Financial Officer at Fortinet

Yes. I think that we called out three things and maybe focusing on two. One, we had a very strong gross margin in the quarter, and I'll elaborate on that in a moment. And then also FX you know, continues to provide a tailwind. More commentary about the gross margin, particularly the product gross margin, as we move through the supply chain challenges and then into inflation, etc., over the last couple of years, I think we've talked publicly that our goal is to try and keep the product gross margin around 61% or so.

The fourth quarter came in obviously very low. We did not anticipate that we'd be able to time our price increases and the cost increases perfectly. So, they went through the income statement in the same quarter, so to speak. And with that, I think you saw a little bit of pressure in the fourth quarter than you saw it kind of revert in the first quarter.

I think, longer term, we also look at product gross margin as an opportunity sometimes for us to continue to invest in growth.

And I think we saw the first quarter gross margin certainly well above that band that I just talked about. And with that in mind, as we start to see some of the costs moving out of the equation, and we introduced new products, I think we'll be looking at that in terms of, is there an opportunity there to make certain investments in growth, while maintaining the margin commitments that we've talked about.

Rob Owens
Analyst at Piper Sandler Companies

Great. And then as a follow-up, I did want to touch on the OT business and the strength you're seeing there. Can you talk a little bit from a go-to-market standpoint? And some of the channel programs, because it does seem like there's some new large channel partners out there that are very excited about the opportunities. Thanks.

Keith Jensen
Chief Financial Officer at Fortinet

Yeah. I think OT, we do look at -- I mean, you're always trying to organize our sales force around verticals, geographies or what have you. And I think when we started to see the opportunity in OT several years ago, Patrice and Ken made a decision to start separating that out and having really a separate sales function and some people that specialize in that.

I do think that we probably got some first-mover advantages by doing that, particularly as we look at Europe and then quickly followed thereafter by the U.S. And, yes, there are some large names that are in that space that are providing technology, not security technology, but technologies in the OT space that have been very receptive, if you will, to conversations and opportunities to meet with us.

Operator

Thank you, very much. One moment for our next question. The next question comes from Adam Borg of Stifel. Your line is open.

Adam Borg
Analyst at Stifel Nicolaus

Awesome. Thanks so much for taking the question. Just for Ken or Keith, obviously, it's great to see the strong collections and the record free cash flow. And you also talked about contract terms being consistent year-on-year. And I was just curious, though, just given the tougher macro, are you seeing any pushback by customers around willingness to pay upfront? And then I have a follow-up.

Keith Jensen
Chief Financial Officer at Fortinet

Yes. Well, first of all, I want to revel in the $600 million of free cash flow, which we been doing for several more quarters. But I'm trying to let people know that a lot of the things fell our way in the quarter. There's always the conversation and part of the sales cycle, if you will. The customer is a lot a one-year, three-year, five-year deal. And certainly, in a rising -- in an environment where interest rates have gone up, I think there's a lot more -- many more conversations that exist around payment terms and things like that.

I do believe that just as we just talked about in the second quarter of 2020, when COVID hit, we have a very strong balance sheet. We obviously have very strong margins. And it's appropriate for us to look to that as opportunities to leverage our balance sheet. Sometimes that may be in the form of extended payment terms or what have you. In our income statement in the form of how we want to go about discounting and supporting growth.

So I think that, again, the strength that we've had, we have the ability to do those things. If the question is around what are we seeing from some of the enterprise customers and Ken is seeing a lot of this as well. Do we see deals that go from five years to three years, sure. Is it more than we've seen in the past? I kind of look back at the contract term data point that we gave and say, maybe but not a lot kind of thing.

And on payment terms, the channel has always offered a financing function. I think they prefer to provide the financing function. And I think we provide support to the financing function to the channel by making capital available to them through payment terms.

Adam Borg
Analyst at Stifel Nicolaus

That's really helpful. And maybe just as a quick follow-up. Head count was up a little bit over 600 people quarter-over-quarter, up over 21.5% year-on-year. Just curious how we think about headcount growth, either in 2Q or later this year, again, just given the macro? Thanks, again.

Ken Xie
Founder, Chairman of the Board and Chief Executive Officer at Fortinet

Yes, we are -- overall, we look at both high coin cost, probably the same pace company grow the top-line and also try to at the same time, try to improving some efficiency there. So, we're not looking for headcount growth above the top-line, even there's still some question area, we also need to do some more investment on investment. But the company so far, we feel we have a pretty healthy finance model. And this also could be the opportunity to also gaining some market share.

Adam Borg
Analyst at Stifel Nicolaus

Great. Thanks again.

Ken Xie
Founder, Chairman of the Board and Chief Executive Officer at Fortinet

Thank you.

Operator

This question comes from Ittai Kidron from Oppenheimer & Company. Your line is open.

Ittai Kidron
Analyst at Oppenheimer & Company

Thanks, guys and nice results. My first question, I guess, is on the U.S. enterprise, so not U.S. in general, but just the enterprise vertical, clearly, one of the most important growth opportunities for you long-term. Can you talk about progress over their win rates displacements? And is the macro making things easier or more difficult for you specifically in the U.S.?

Ken Xie
Founder, Chairman of the Board and Chief Executive Officer at Fortinet

First, we continue to invest in the U.S. enterprise. We also see a huge growth potential for us because we have a relatively small market share. And with all the strong product technology we have. On the other side, the big environment definitely slowed down some of the enterprise making certain decisions, whether a refresh or something like that. But on the other side, our solution has a better, lower total cost of ownership and also can expand beyond the traditional network security and also helping customers to consolidate. So, I think all this combined together, we do see the U.S. enterprise definitely a strong growth area for us.

Ittai Kidron
Analyst at Oppenheimer & Company

Okay. Thanks. And then maybe a follow-up on the competitive side, then Ken, maybe you can talk about what have you seen out of your competitors here in the US, any kind of abnormal activity from discounting or otherwise?

Ken Xie
Founder, Chairman of the Board and Chief Executive Officer at Fortinet

I think in the slowdown of some of the big environment, definitely the competitors starting to be more aggressive, whether on some discount or offer some free, some of the -- some percentage of free service. But from our angle, we see we have much better product position, much broad like infrastructure coverage and better service. And also both on the performance angle, the product definitely has performed much better for the same countries in cost at the same time.

Our service also has much more value and cost lower than competitors. So, for us, we have not experienced like price pressure or discount pressure. It's more about how we can increase the coverage, increase the -- the lead gen pipeline and also to meet the customer need in this big environment change.

Ittai Kidron
Analyst at Oppenheimer & Company

Thank you.

Ken Xie
Founder, Chairman of the Board and Chief Executive Officer at Fortinet

I would think that what Ken talked about, I think, is fantastic. I think keep in mind, we don't -- we have a very -- as we kind of talked about in prepared remarks, a very diverse customer base, if you will, between being international, between being very large, mid, small, and MSSPs, etcetera. So, I don't want to put a policy in place that covers every geography and it covers every customer size.

And I think what you're really talking about here is something that for us represents 15% of our business, maybe just a little bit less. And because it's at that size, it's something that we can really more, I think, target our responses to as we get deeper into the selling function as opposed to some broad announcement that we're going to give away services for two years or something like that.

Ittai Kidron
Analyst at Oppenheimer & Company

Very good. Thank you.

Operator

Thank you. One moment for next questions. This question comes from the line of Angie Song with Morgan Stanley. Your line is open.

Hamza Fodderwala
Analyst at Morgan Stanley

Hi. Thank you so much for taking my questions. I'm on for -- Hamza Fodderwala of Morgan Stanley. So, could you just share a little bit more about your current interest around the SASE -- or current customer interest around the SASE product? And -- what are some of the responses around it so far?

Ken Xie
Founder, Chairman of the Board and Chief Executive Officer at Fortinet

It's a pretty strong growth. And also, we're working with a lot of our service providers, both on the infrastructure side or security service side. And offer SASE because we do believe SASE should be ecosystem with a lot of players instead of just a vendor offer their own SASE because a lot of -- I say, probably most customers, they prefer some of their data being processed control themselves, whether some private SASE or some data solvency keeping the data within certain geo.

So, that's where we see the SASE approach, we call Universal SASE, the customer flexibility to offer both cloud-based or on-premise based or kind of lack the service provider, infrastructure will be more benefited the whole industry long term. And so that's where -- even sometimes we kind of take a little bit more time to develop our SASE function in the single OS, but that's make it more easy for the customer, for the service provider to deploy SASE to see their environment. So we see a very, very healthy pipeline and the strong growth, kind of a salary growth. And that's also based on a more healthy margin model instead of -- do see money all of our growth. So we want to maintain that model and also working closely with our partner to offer kind of SASE together to the customer.

Hamza Fodderwala
Analyst at Morgan Stanley

Got it. Thank you. And just one more around profitability. So how are you guys thinking about -- slows down over the next few years? And where do we see that margin leverage?

Peter Salkowski
Vice President, Investor Relations -Fortinet, Inc at Fortinet

Angie, can you repeat that? You cut out at the beginning of that question.

Hamza Fodderwala
Analyst at Morgan Stanley

Yes. No worries. So the question is around profitability. And I was just wondering, what you guys are thinking about upside to profitability as growth slows down. And where should we expect to see that margin leverage?

Ken Xie
Founder, Chairman of the Board and Chief Executive Officer at Fortinet

We see the midterm model will be time-date and built in by 2025 with non-GAAP operating margin at least 25% for each year in the next three years.

Hamza Fodderwala
Analyst at Morgan Stanley

Got it. Thank you.

Keith Jensen
Chief Financial Officer at Fortinet

Yes. I think the -- one thing, Angie, and I think to about this before as well. Keep in mind, two-thirds of the business roughly is service revenue, and that's producing gross margin that's in the mid-80s. So -- and that's -- those are longer-term contracts. So I think we -- the business model is such that we have time to react if there was something really dramatic that happened in the industry. But part of that is for that to happen, I think you probably have to see some sort of shift in the behavior of the bad actors, the nation states, the organized crime groups, etcetera, and we don't see that, that's on the landscape.

Hamza Fodderwala
Analyst at Morgan Stanley

Thank you, so much.

Operator

Thank you. Please stand-by for next question. This question comes from the line of Tal Liani of Bank of America. Your line is open.

Tal Liani
Analyst at Bank of America

Hi guys. What we've seen with good companies in the last two quarters is that they make great numbers. But when you look at the composition, new customers are slowing down and sales to existing customers are going up and we've seen it through multiple companies in the space. So the question is whether you can provide us with some data on sales to existing customers versus new customers? And how is the current environment on customer acquisition on new customer acquisition? Thanks.

Keith Jensen
Chief Financial Officer at Fortinet

Yes. So as a reminder, it's all good to hear from you again. If you think of the business being extremely diversified, whether that's geographically or by customer segments, one-third small, one-third mid, one-third large. We specifically called out in the script that we added over 6,000 new logos in the quarter. So obviously -- and that's probably a growth rate that's easily in the double digits. New logos take a while to really produce revenue for us. It tends to be less than 10% of total revenue from the new logo. So it creates the opportunity to continue to sell into them. Kind of Ken's comment a moment ago to your question here, do we see large enterprises in the U.S. still moving forward robustly with all their various digital transformation projects. I think that the word on the Street is that slowed down a little bit. And in that environment, I do think that incumbents sometimes have an advantage, but also a cost of performance argument and debate is something that you see customers perhaps more receptive to in the current macro environment.

Tal Liani
Analyst at Bank of America

And in the current macro environment, is the duration of contracts going down? Or again,

Keith Jensen
Chief Financial Officer at Fortinet

It was flat year-over-year, down one month quarter-over-quarter

Tal Liani
Analyst at Bank of America

Got it. Okay. Thanks.

Keith Jensen
Chief Financial Officer at Fortinet

Which, as somebody reminds me in the room very politely, every first quarter is down one month.

Tal Liani
Analyst at Bank of America

Got it.

Keith Jensen
Chief Financial Officer at Fortinet

Good question.

Tal Liani
Analyst at Bank of America

Yeah.

Operator

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

Andrew Nowinski
Analyst at Wells Fargo & Company

Okay. Thank you and congrats on nice quarter, so I wanted to ask about your SASE offering as well. You talked at the Accelerate conference about, I think having 8 to 10 new use cases driving demand for the firewall, but I'm wondering if SASE could be one of those use cases as well, meaning is the firewall appliance a critical component of your SASE offering.

Ken Xie
Founder, Chairman of the Board and Chief Executive Officer at Fortinet

Yeah. SASE is definitely is one of the use case, especially the Universal SASE or sometimes they call the Private SASE for some customer or some service provider, they want to have more control of their data. So that we see is -- both SASE like the service model, customer benefit and service provider has a big value add in that one. But at the same time, given the flexibility of whether for some traffic to the cloud or to the power have a process on premise and by the appliance. So that's we see the huge benefit of our Universal SASE solution, which is very different than some other SASE players and a lot of customers and the partner are interested in this Universal-SASE approach.

Andrew Nowinski
Analyst at Wells Fargo & Company

Thanks Ken. And then, maybe a question for Keith, just as it relates to your capex. You talked about a component of that being used to build out more pops to support the SASE offering. But is that something -- like how should we think about capex in that investment beyond 2023, as you continue building out your network?

Keith Jensen
Chief Financial Officer at Fortinet

Ken and I are smiling each other. We've had this conversation. I think I've been here for nine years of this week. One thing I've come to appreciate is Ken behave like a long-term investor. And with that in mind, owning critical real estate assets tends to have a better payback than leasing them over an extended period of time, whether that's in R&D facilities, whether that's in manufacturing or warehouse facilities, or that as we move into the SASE market as well as other cloud offerings. It's not just investments in SASE, if you will, but it's also investments in larger data centers in order to deliver various cloud-based services and solutions. And I think you've heard us talk about that in the last several earnings calls and the guys of data centers having an impact on margins for services and capex spending. So I don't think there should be a surprise there, but I think it is an indication of our looking to expand into more fully into some of these other markets.

Andrew Nowinski
Analyst at Wells Fargo & Company

Got it. Thank you.

Operator

And thank you. One moment for our final question. Our last question comes from the line of Shrenik Kothari from Baird. Your line is open.

Shrenik Kothari
Analyst at Robert W. Baird

Hey, thanks for taking my question. So for Ken or Pete, I think, Keith, you mentioned about the financial services up over 40%, which is surprisingly strong and contrary to what we are hearing from your peers and competitors. So can you expand a bit about -- upon the underlying drivers? I know you touched upon it but I just wanted to expand on the geographical diversity? Or is it increased kind of impetus for vendor consolidation that is benefiting you guys in that vertical? If you can just elaborate and then I have a quick follow-up.

Keith Jensen
Chief Financial Officer at Fortinet

Yes. I would say it's all of the above. It's happening geographically. I think it's happening with customers that we took down earlier that are expanding with us with additional firewalls and additional security or additional services as well. I think the market, if you will, financial services, if you step back and look at what's happening there, specifically the firewalls over the last several years, there's probably two legacy vendors there that when they're contracts are up for renewal, and we've talked about this a long period of time. Now they're exposed and increasing opportunity to come in for a competitive displacement. And I think that some of the other comments or questions today is it more difficult in this environment for competitive placements. I mean, sure, you've got to work a lot harder to make it happen. You got to make your value proposition more well known. But I think, again, I think it's expansion. I think it's opportunity to displace incumbents and I don't think it's specific to any 1 particular geography.

Ken Xie
Founder, Chairman of the Board and Chief Executive Officer at Fortinet

Also from technology and go on, we have a huge advantage on for the internal segmentation of security data center. So because the ASIC advantage we have, we can deploy in the very high-speed environment, which a lot of us finance service provider, they do need to secure their kind of internal segmentation there. The other part, really, some of finance services are also starting to supporting work from home, working from remotely, which we also have a super solution with our ASIC based like small appliance and supporting this kind of a very broad infrastructure approach combined with like SD-WAN or the other 5G, 4G network and security together. So that's give us huge advantage from the product.

Shrenik Kothari
Analyst at Robert W. Baird

Got it. Got it. Thanks a lot Ken, Keith. Just a quick follow-up. And you guys, of course, started upon the expansion opportunity in the form factors. Of course, your peers and parties have spoken about unit expansion pressure and how the product unit growth is kind of normalizing. But just wondering, given that give examples of this eight-figure expansion and upsell opportunity replacing kind of firewall with a holistic solution. Can you talk about like expansion drivers broadly like -- are you seeing mostly upsell and expansion in form factors versus the units? Just imparted to get some clarification there.

Ken Xie
Founder, Chairman of the Board and Chief Executive Officer at Fortinet

Probably both. Yes, we do see the expanding of both the unit and also upsell cross-sell of the entire for the Security Fabric, which has 53 product. So that's where both our internal sales force also partners setting after across for the whole fabric. At the same time, because we combine networking security and more function together multiply case, which also the unit shipment also starting keeping grow quite nicely.

Shrenik Kothari
Analyst at Robert W. Baird

Got it. Thanks a lot. Ken, appreciate it.

Ken Xie
Founder, Chairman of the Board and Chief Executive Officer at Fortinet

Yeah. Thank you.

Operator

Thank you. That concludes the Q&A segment. I'll now turn it back over to Peter Salkowski for closing remarks.

Peter Salkowski
Vice President, Investor Relations -Fortinet, Inc at Fortinet

Thank you, Chris. Apologies to the seven people who were left in the queue. I'd like to thank everyone for joining today's call. Fortinet will be attending investor conferences hosted by JPMorgan and Bank of America during the second quarter. Fireside chat webcast link will be posted on the Events and Presentations section of the Fortinet Investor Relations website. If you have any questions, please feel free to contact me. Have a great rest of your day. Thank you.

Operator

[Operator Closing Remarks]

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