Good day, ladies and gentlemen, and welcome to the Fortinet Q3 2018 Earnings Announcement Conference Call. At this time, all participants are in a listen only mode. Later, we will conduct a question and answer session and instructions will follow at that time. As a reminder, this conference is being recorded. I would now like to introduce you to your host for today's conference, Peter Salkowski, Vice President of Investor Relations.
You may begin.
Thank you, Gigi. Good afternoon, everyone. This is Peter Salkowski, Vice President of Investor Relations at Fortinet. I'm pleased to welcome everyone to our call to discuss Fortinet's financial results for the Q3 of 2018. 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 our call today by providing a high level perspective on our business. Keith will then review our financial and operating results and conclude by providing our guidance for the 4th quarter before opening up the call for questions. During the Q and A session, we ask that you please keep your questions brief and limit yourself to one question and one follow-up to allow for others to participate. Before we begin, I'd like to remind everyone that we will be making forward looking statements on today's call and that these forward looking statements are subject to risks and uncertainties that 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 ks and Forms 10 Q for more information. All forward looking statements reflect our opinions only as of the date of this presentation, and we undertake no obligation and specifically disclaim any obligation to update forward looking statements. Also, all references to financial metrics that we make on the call today are non GAAP unless otherwise stated. Our GAAP results and GAAP to non GAAP reconciliations can be found in our earnings press release and in the presentation that accompanies today's remarks, both of which are posted on our Investor Relations website. Lastly, all references to growth are on a year over year basis unless noted otherwise.
I will now turn the call over to Ken.
Thanks, Peter, and thank you to everyone for joining for this call to discuss our Q3 2018 results. I'm pleased with our strong Q3 results as Bilibili increased 22% to RMB528 1,000,000. Total revenue was up 21 percent or $454,000,000 with product revenue up a solid 20%. Non GAAP operation margin was 24%. We post non GAAP earnings per share of $0.49 and were again profitable on a GAAP basis with earnings per share of $0.33 We aim to continue to deliver above market growth balanced with profitability.
We are experiencing strong global demand for our security fabric platform due to enterprise digital transformation, increasing consolidation and the network security refresh cycle. Today, enterprise needs security that will go well beyond isolated security point product. This trend are expanding and opening up new opportunity for a broad integrated and automated security fabric protection. The security fabric platform offers 3 major competitive advantages. First, our fabric platform offers a broader set of end to end solution providing protection from IoT to data center both on premise and cloud.
Organically built from ground up from 2 decades of innovation, the security fabric provides the best automation and innovation in the industry. An example is our security fabric cloud offering on Azure. We now provide the most extensive offering of integrated security solution available on Azure, including FortiGate next generation firewall for the sandbox, for the CASB, for the web, for the mail, for the manager and for the analyzers. A second differentiator is our superior price to performance capabilities. Fortinet is the only security company that build ASIC security processor, SPU, with integrated security and network functionality, which provide 10x the speed and performance of other software approach.
As a result, full fledged product provides significant better security performance for both cloud and edge computing. The 3rd competitive differentiator is our security fabric platform is the extensive third party recognition and validation we have received from NSS Lab and Gartner. Fortinet has received a recommended rating in 9 out of 9 NSS Lab categories, more than double the number of recommendations received by our nearest competitors. Fortinet was among the only 3 vendors out of 10 that received a recommendation for their SD WAN solution and the only vendor who had received recommended rating in both SD WAN and the next generation firewall group test. Foden and Fabry platform solution have now appeared in 7 Diner Magic Quadrant over the past 12 months.
Our SD WAN solution was recognized as one of the top five solution in Gartner's 1H Magic Quadrant. Also Fortinet was named in both the leaders quadrant for next generation enterprise firewall and unified threat management. SD WAN plays a pivotal role in realizing the true benefit of digital transformation and is forecast to reach $4,500,000,000 by 2022, up from $1,000,000,000 in 2018. Garner state that by 2023, 50 percent of new firewall purchases in the distributed network will utilize SD WAN features. Fortinet offers the only solution that provides both SD WAN and the next gen firewall functionality in a single integrated offering for enterprise and SMB.
We believe this technology advantage put Fortinet in a solid position to capitalize on strong SD WAN market growth. Last week, Fortinet announced the acquisition of ZoneFox, a cloud based insight threat detection and response company. The acquisition further enhanced the security fabric platform and strengthened our existing endpoint and same security through machine learning, providing a better and faster response to inside threat. Innovation is core to Fortinet's mission. In the Q3, we surpassed a milestone of 500 issued patents, 3 times the patents issued for our nearest competitors.
We are pleased to be added to the S and P 500 Index, an acknowledgment of a double digit year over year growth every quarter since going public in November 2009 and our consistent GAAP profitability. We are excited about significant opportunity ahead and we will continue to invest while achieving a goal of 25% operational margin at 2022. I want to thank the Fortinet team and our partner for their ongoing hard work and our customers for their support. Now, I will turn the call over to Keith for a closer look at our Q3 performance and our Q4 guidance.
Thank you, Ken. Before I start, I'd like to note except for revenue, all financial figures are non GAAP and growth rates are based on comparisons to the prior year period unless stated otherwise. Any slide references that I make during my prepared remarks refer to the presentation that is posted on our Investor Relations website. I'm very pleased with our Q3 results as the Fortinet Fabric continued to resonate with existing and new customers. In the Q3, we posted revenue growth that outpaced the industry and operating margin that was better than expected and strong free cash flow.
We believe we are well positioned to outperform the security market in the Q4. We are delivering an integrated and high performing fabric product portfolio that is driving an industry leadership position. This claim is supported by the independent recommendations we received from NSS Labs and Gartner. Specifically, I would point to our 9 for-nine record of NSS Labs product recommendations as well as Gartner evaluating Fortinet as a leader in both their UPM and Enterprise Firewall Magic Quadrants. We remain committed to balancing above market revenue growth with increasing profitability as we work to achieve our non GAAP operating margin goal of 25% for the full year 2022.
Now for our Q3 results, starting with revenue. As shown on Slide 3, revenue grew 21% to $454,000,000 Product revenue growth accelerated to 20%, resulting in revenue of $165,000,000 Product revenue included a net benefit of $2,000,000 related to the required accounting change on revenue. Excluding this benefit, product revenue growth accelerated to 18%. Service revenue grew 22% to $289,000,000 SupportiCare, our traditional support offering, grew 26% to $121,000,000 and FortiGuard, our security subscription offering, grew 20% to 157,000,000 dollars Deferred revenue increased 27 percent to $1,500,000,000 Average contract length increased 1 month to 26 months and was flat sequentially. Turning now to billings.
Billings grew 22% to 528,000,000 dollars Each region experienced strong billings growth with the Americas, APAC and EMEA up 25%, 22% and 19%, respectively. The U. S. Provided strong enterprise growth in the quarter, accounting for 7 of our top 10 and the majority of our top 25 customer billings. Billings to our Global 2,000 customers, excluding service providers and MSSPs, on a trailing 12 month basis, grew 31%.
1 of our top 25 billings in the quarter was a 7 figure transaction with the same large U. S. Retailer we highlighted in the Q1, there then 7 figure all cloud transaction. The new transaction is focused on our ASIC based FortiGates, including several of our high end 6,000 series of products. These high end FortiGate products will be deployed to secure connectivity with their earlier cloud deployment.
We also completed a quadruple competitor displacement with a large U. S.-based financial services firm initially looking to improve their internal segmentation capabilities. After a very successful proof of concept, the firm decided to displace additional vendors, consolidating their functionality with Fortinet and lowering their total cost of ownership. Also in the quarter, the large U. S.
Multinational financial services firm that was highlighted in our last call appeared again as a top 10 customer with another 7 figure billing this quarter. Illustrating the strength of our midenterprise and enterprise business, the number of deals over $250,000 grew 27%, while the billings associated with these deals increased 34%. Number of deals over $1,000,000 were fairly consistent year over year, moving from 32 to 30. The total dollar billings associated with these $1,000,000 plus deals increased 32%. Service Providers and MMS and MSSPs continued as our largest vertical, accounting for 19% of billings, up 2 points year over year.
Network security billings increased 22%, accounting for slightly more than 3 quarters of total billings. Billings for non FortiGate grew faster than the FortiGate business. The security fabric, which is the largest component of our non FortiGate offerings, benefited from customers' recognition of its value, performance and integrated security coverage. Cloud billings for our top 5 public cloud providers continued to experience growth in excess of 100%. Moving back to the income statement.
Our 3rd quarter gross margin increased 50 basis points to 76.5%. Product gross margin was down 120 basis points to 57.4%. On a quarter over quarter basis, product gross margins were up 90 basis points as we continue to transition through a certain level of volatility related to new product introductions. Service margins expanded 120 basis points to 87.3 percent and 50 basis points sequentially. Including the commission benefit associated with the required change in accounting, total operating expenses grew 11%.
Excluding the benefit from the required commission accounting change, total operating expenses would have been up 15%. Including a 2 40 basis point benefit from the commission and revenue accounting changes, our operating margin of 23.9 percent was up 5 20 basis points year over year. Excluding any benefit from these accounting changes, our 3rd quarter operating margin increased by 280 basis points year over year. The operating margin improvement was mostly driven by leverage in our financial model as revenue growth outpaced total operating expenses. Slide 14 shows a line by line comparison between our non GAAP results and the non GAAP results excluding the adoption of the new accounting rules.
In the Q4, we expect total operating margin benefit from the required accounting changes to be about 2 50 basis points. For the full year, the operating margin benefit is expected to be about 300 basis points. Total headcount at the end of the 3rd quarter was 5,639, up 15%. Net income for the 3rd quarter was $87,000,000 or $0.49 per share based on 175,700,000 diluted shares and was up 75% year over year. Non GAAP effective tax rate was 24%.
Moving to cash flow and capital summarized on Slide 7. Cash from operations was $177,000,000 up 9% year over year. Free cash flow was 159,000,000 dollars up 13% year over year. On a year to date basis, free cash flow increased 32% to 417,000,000 dollars Capital expenditures in the 3rd quarter were $18,000,000 Given the strong growth we've experienced, we will outgrow our existing office space in Sunnyvale. As a result, we have started construction on a building adjacent to our existing office.
In the Q4, we expect capital expenditures in the range of $5,000,000 to $10,000,000 related to this building. We expect total 4th quarter capital expenditures to be between $20,000,000 $30,000,000 Total capital expenditures for 2018 are expected to be between $60,000,000 $70,000,000 Capital expenditures related to the adjacent building are expected to be in the range of $60,000,000 to $80,000,000 in 2019. We plan to provide quarterly spending updates throughout 2019 and plan to move into the building in 2020. As I turn to guidance provided on Slide 9, I'd like to remind everyone that the forward looking disclaimer Peter presented at the start of the call applies to the guidance I'm about to provide. For the Q4, including the benefit of ASC 606 and an immaterial impact from tariffs on cost of goods sold, we expect billings in the range of $620,000,000 to 635,000,000 revenue in the range of $490,000,000 to $500,000,000 non GAAP gross margin of 75% to 76% non GAAP operating margin of 24.0 percent to 24.5 percent non GAAP earnings per share of $0.50 to $0.52 which assumes a share count of between $178,000,000 $179,000,000 For 2018, including the benefit of ASC 606 and an immaterial impact from tariffs on cost of goods sold, we expect billings in the range of 2,125,000,000 dollars to $2,140,000,000 revenue in the range of $1,785,000,000 to 1,795,000,000 dollars non GAAP gross margin of 75% to 76%, non GAAP operating margin of 21.5% to 22% and non GAAP earnings per share of $1.72 to $1.76 which assumes a share count of between $174,000,000 176,000.
Before I turn the call back over to Peter, I'd like to thank our partners, our customers and the Fortinet team for all their support and hard work. I'd also like to welcome the employees of ZoneFox to the Fortinet family. I'll now hand the call back to Peter.
Thank you, Keith. Operator, we're ready to open up the call for Q and A, please.
And our first question is from Jonathan Ho from William Blair. Your line is now open.
Hi, good afternoon and congratulations on the strong quarter. I just wanted to start out with maybe the security fabric. It sounds like this was another strong quarter in terms of demand. Can you maybe give us a little bit more detail in terms of what elements of the fabric maybe stood out? And also, do you have a separate quota for the sales force to retire related to the security fabric?
Jonathan, it's Keith. Second question first, no, we do not have a separate quota for the fabric for the sales team. If you look to the product family, I would highlight the access points and the switches performed very well in the quarter, and that continues a pattern that we started see shaping up in the beginning of the quarter as well. I think also I would add to that list, 4 d Manager, 4 d Analyzer, 4 d SIM. Overall, the product suite of the fabric performed very well during the quarter.
Excellent. And then just looking at the operating margin trends, I mean, you guys have guided to a pretty strong operating margin in the Q4 after delivering a strong Q3. How should we be thinking about that on a go forward basis? I know you guys make some investments early in the year as well that start to show leverage, but I just want to make sure that we're thinking about that the right way.
Yes. And we're not in a position as we go through the budgeting cycle that we're in right now for the coming year to really talk about guidance for 2019. Obviously, we're very pleased with the performance of the company in Q3 on the top line and on the operating margin line. I think the productivity from the sales organization, you're seeing that come into play in the Q3. We're very pleased with that.
I'll probably leave it to Ken to talk a little bit about market forces and what we're seeing beyond just fabric growth, but other comments as well.
Yes. Actually, with our strong building growth, like 22%, our high comp hiring probably a little bit behind that. So the healthy way for long term growth need to be synced together for the top line growth and the headcount growth. So that's where we may catch up a little bit. On the other side, we do see the refresh cycle still going on, maybe it will be last another 1 to 2 years.
The other opportunity we see is SD WAN is a huge opportunity. Like I mentioned in the script, in the next few years, we'll be reached from this year 1,000,000,000 to 5,000,000,000 and where only vendor can provide both SD WAN and also security and yes, single box, single solution. It's a huge advantage for a lot of enterprise SMB service provider. We see a very strong demand. We believe this trend will be carried for another few years of growth, very strong growth.
So that's where we want to keep in balance among the growth and profitability. So we were the company to clear both the top line and the bottom line. We also have to come in and 25% operating margin by 2022, but we also want to keep in imagine the growth going forward.
Great. Thank you.
Thank you. Our next question is from Sterling Auty from JPMorgan. Your line is now open.
Yes, thanks. Hi, guys. I get a number of questions from investors trying to understand, especially in the high end enterprise, how much of the demand and segmentation. So just maybe some additional color around what's driving the success in particular in the high end enterprise part of your business?
We do see both growing well, whether in the data center cloud and also in the internal and internal segmentation and edge computing. Because once the enterprise starting realize really when they move the data to the cloud, they also need to securely access to it and actually add some additional risk because now in the cloud is if you cannot secure access that, the data probably more risk, more danger there. So that's how to secure access the data, especially leverage like SSL encryption or other things are very, very important. But most other current security solution there have a big performance issue with access encryption. But we have the ASIC solution which when you do the SSL encryption for the traffic, you almost know no traffic drop compared to the other solution test by the NSS, about 80% drop of the throughput.
So that's what we see is for the enterprise when they have this hybrid and I'll move some data to the cloud compared some more internally. So they need a balance amount what's the data go to the cloud, what's the data what's the computing still within the edge, within enterprise. So we see enterprise definitely keeping increased security spending even some patent IT spending probably pretty much flat. So it's still very healthy and we continue to believe the security will grow like 10% or even above in the next 10 plus years. The total market size can reach like $1,000,000,000,000 in the next 10 to 20 years.
It's a very healthy long term growth market.
Got it. Thank you.
Thank you. Thank you. Our next question is from Shaul Eyal from Oppenheimer and Company. Your line is now open.
Ken, probably one for you, one for Keith. Going back to the refresh product cycle, you've been around your entire career within the security arena. As you think about the current cycle, would you characterize it as if we're in the initial innings, midway? How would you think about it versus prior cycles, timing and maybe even demand and product wise? Thank you.
I feel this cycle compared to the rush by happening in the end of 2012, 2013, This probably lasts a little bit longer, maybe a few quarter longer, maybe last for like 2 years 2 1.5, 3 years. We are probably close to the middle of it, but it's the difference is this time they consider multiple solutions together, whether co fabric or platform. So they also need to find a way to integrate or automate a solution compared to the last cycle they just refresh from the regular firewall to the next gen firewall UPM. And that's where this time they need to consider how these different piece can work in together whether from the network side, the endpoint, the cloud, the networking side, even some storage and IoT. So that's where they try to have a more bigger picture kind of infrastructure kind of approach compared to just the network side.
So that but also we see some kind of a new infrastructure whether the IC WAN or the 5 gs similar like in the past, we see also very strong part of fabric growth. The Wi Fi also need to be considered together with security. So that's what we see as kind of a total infrastructure fabric platform approach is happening right now and consider the security more integrate or designed with the infrastructure instead of just like add on top of some infrastructure.
Got it. Understood. Thank you so much for this color. Maybe one for Keith. Really strong showing on the DSO front, probably lowest in some quarters, doesn't matter whether it's 605 or even 606.
Can you talk to us about that and maybe also about seniority trends you have been experiencing through the quarter? Thank you.
Yes. Thanks for your nice comments. Yes, I think DSO came in, I don't think there was anything really unnatural in the numbers. And that just kind of leads up to your second part of your point. I think linearity in the quarter was indeed good, and it kind of held its pace.
I commented on about the 1st month of the quarter and the last earnings call being good. And I think it kind of continued on through the quarter. And I think you're seeing that in the DSO number.
Our next question is from Andrew Nowinski from Piper Jaffray. Your line is now open. Andrew Nowinski, your line is now open. Andrew Nowinski?
Yes. I'm on you can hear me?
Yes. We can hear you now.
All right. Thank you. Congrats on a nice quarter. I just want to ask about the large customer win that you had, the quadruple replacements. Since that was clearly more than a firewall replacement, can you give us any color as to what products that customer consolidated onto the Fortinet platform?
Yes. You're going to when you start to see multiple products like that, it's going to go beyond the firewall right into the fabric, right? And more often than not, you'll see, as I indicated previously, from a hardware viewpoint, the access points and the switches are doing very well. And then you roll into that typically a suite of 4 d Manager, 4 d Analyzer, SIEM, cloud, etcetera.
Okay, got it. And then just maybe a comment on the large deals, they looked like they were down. I'm talking about the $1,000,000 deals were down sequentially. Did any deals push out into Q4 that might have caused that number to be down year over year?
I don't I think when you look at that population, again, I think it was off by 2, I think year over year from 32 to 30. You're going to get a little bit of volatility in that segment of the market, so I'm not surprised by it. I was very pleased to see the total dollar value that was billed in those large deals, even though the number was smaller, the total billings were up about 34%, I believe I said.
Okay, got it. Thanks. Congrats.
Thank you.
Thank you. Our next question is from Keith Bachman from Bank of Montreal. Your line is now open.
Good evening. Thank you. I wanted to ask 2 questions if I could. First, the services revenue has been humming along at 25%, 26% year over year growth for 5 quarters. This quarter it de sold a little bit, again larger number, but de sold to 22% while the product revenue, its 2nd straight quarter of really good growth.
And so I'm just wondering was there anything on the services side, any reason why it decel side of larger numbers? And what does that portend that the product revenue growth has been so strong for a couple of quarters now? Does that suggest an inflection point in terms of acceleration back to the services side? Then I have a follow-up if I could.
Okay. Keith, it's Keith. How are you?
Great. Thank you.
Look, I think, obviously, we're very pleased with the results of the quarter, both from the top line and the bottom line. And as you know, we manage or we guide to total revenue into the margins. So within that mix of services and products, we're very pleased with where we end up, including the gross margin line. If you get a little more specific to your question, one thing we looked at was our renewal rates were very good in the quarter, up over what we normally see. Attach rates were very good.
The mix of 24x7 versus 8x5 support was very good. It picked up again. As I said, renewal rates attach rates. So I think it's a larger base as part of it, as you point out. I think the other key element of this is something that we talked about a little bit in the Analyst Day.
As the fabric platform came online, we expected it to bring with it a higher mix of hardware. And that higher mix of hardware, what you're seeing in the top line on the product revenue growth and then a smaller mix on services. And I would really point to access points and switches for that. So I think you're really starting to see the impact of the platform strategy from the fabric and how it's appearing and the success it's driving in the income statement.
Also, we introduced a new service called the FortiCare 360. That's beyond the traditional FortiCare 8x5 supporting and 20 fourseven supporting. This will be helping the fabric service going forward. It's helping to manage to configure to deploy and also to help check off some of the fabric solution there. It's still in the early ramp up stage and but we do believe including the future fabric and also the new trend SD WAN.
So this service needed and we see also very quickly ramp up even just in the very early stage. We do believe this will help in the future service growth.
Okay. And then my clarification, Keith, is just you guys have provided operating margins for the year. And let's just say for giggles, it ends up being 22% operating margin pursuant to AS 606. When you talk about growing to that target of 25%, I assume the base that we should think about in 2019 is 22%. In other words, the base isn't ex the benefit of the accounting translation as we think about 'nineteen?
Yes.
I think the way we've always described it is that that's a 605 number, and we're tracking to 605. And as and part of that, the reason we're looking at the 605 number in terms of that commitment is, as you can see, it's moving around on us, right? It's come down from the Q1 to the Q4, and that can be impacted by things like product revenue mix, comp plans, service term, etcetera. So I think just to keep us all very honest on our side of the table, it's a 605 goal.
Okay. But as we think so if we think about 2019, again, just using 22% as the reference points, should we expect operating margins to be flat, down or up relative to 22%?
For 2019?
Yes.
Yes. I'm going to pause on providing guidance for 2019 other than offering up our long term model that we've talked about before and what we're targeting over time.
Okay.
This is actually let me go through my budgeting process and cycle before I do that.
Okay. Thank you.
Thank you. Our next question is from Gabriela Borges from Goldman Sachs. Your line is now open.
Good afternoon. Thank you. I wanted to follow-up on some of the momentum you're seeing in the Global 2,000 either for Ken or for Keith. Could you comment on to what extent the volume of opportunities, the number of engagements that you're invited to bid upon, how is that changing relative to history? And then if you could also comment on win rates for Global 2000 Business.
Once you're invited, how often do you win? Is that number changing at all? Thank you.
Hi, Gabriela, it's Keith. How are you? I would say the pipeline in total, we're very pleased with the direction of the pipeline. And the segmentation of the pipeline, I think the fact that I'm pleased applies to both our very important SMB part of our business and also the Global 2,000 part of the business. Yes, I think the we're well positioned with an opportunity to continue to lead the SMB and expand into the enterprise.
And I think that trailing 12 month number 31% growth, is a very positive indicator. In terms of wins and losses, that's we're not other than the carrier MSSP, we're not the incumbent. It's always a little more challenging to displace the incumbent, but I think when we have those opportunities, we're doing well and we're very pleased with it.
Yes. Also, we I didn't invest in the market chain in supporting to support the sales into the Global 2,000. We see pretty good progress there. And at the same time, even within the sales, we're starting kind of separate some of the effort of our organization, whether focusing on channel or focusing the Global 2,000. So that's where once we have the focus, we can see the growth pretty healthy.
That's helpful. Thank you. And follow-up on the gross margin. I appreciate that gross margins are expanding in aggregate year over year, but I wanted to ask specifically on product gross margin. Could you help us understand for Keith when that number might start to trend upwards or when you might start to see stabilization within that product gross margin line?
Yes, I think that's a fair question. I'd probably just going to offer you some context. It can be impacted by the mix, obviously, between products and services in any quarter. Specifically, when you look to Q3 to Q4, the sequentiality, our mix typically picks up a little bit the product, which puts a little bit of pressure on the gross margin line. I do expect that we're going to continue to see growth and improvement in total gross margin and largely driven by the services component of that.
And I think we're kind of fast forward to the punch line, we're on track to that 25% goal and that gross margin line is a component of that.
Yes. Also like early this year during the Analyst Day preview there annual salary, we do see the long term gross margin target is 80%. And at the same time, we refresh some of the middle range product. During the refresh time, the gross margin just dropped a little bit and then will become back up once the ramp up starting refresh, starting finish. So we do see the long term trend still the same and we're still keeping the 80% target for gross margin long term.
I appreciate the color. Thank you.
Thank you.
Thank you. Our next question is from Fatima Boolani from UBS. Your line is now open.
Good afternoon. Thank you for taking the questions. Keith, maybe to start with you, just on the service provider business, just according to my math, that was a nice acceleration off of the Q2. So maybe can you give us a sense of what sort of budgeting behavior is actually playing out in the service provider vertical that underpin the strength? And as we look into next year, what sort of activity are you anticipating?
Another follow-up, if I may.
Yes. I think the and Ken may want to weigh in here a little bit, but I think the MSSPs portion of that service provider is really what you're seeing, and that's historically been the largest part of our business, and we're seeing that do exceedingly well. I think the SD WAN discussion now is really coming into play as part of that business as well. And I think you're seeing that starting to drive then we've had some conversations with customers. That SD WAN opportunity is really starting to drive some pipeline growth.
I think 5 gs will be a part of it as well, right?
Yes, I agree. Yes, that's where we do see the SD WAN technology starting kind of being used by some new relatively small service provider trying to get market share from the traditional MPLS offered by some of the bigger carrier service provider. So at the same time, the 5 gs, some other technology starting taking off now. So our philosophy is already working with service all kind of service provider, both large and small and offer the best product and tool and design the security into the infrastructure into the service they're offering. So we see this strategy working quite well.
That's where we're the only one offer SD WAN together with security, the Wi Fi together with security and also going forward, some other new things always security together. So that's the strategy the service provider like a lot. That's what compared to some other whether network vendor or the security vendor, they have to catch up to buying company to follow the trend compared with kind of a long term invest in all this area a few years ago and keeping investing for the long term and offer integrate automated solution, which is much better for the service provider for the customer.
That's helpful. And Keith, just a quick one. Last couple of quarters, you gave us some color on shipment volume. I just wanted to see if there is an update there and to the extent it's sort of held into that the 20% -ish zip code. How should we think about that from a sustainable basis looking out the next couple of years as we think about hybrid architectures and cloud migration?
And that's it for me. Thank you.
Yes. Sorry about that. I know we were just consolidating on words in my script. 48 Unit shipments up 16% year over year, all shipments up 20% year over year. I mean, for 'twenty one, but I'll go with 'twenty.
Thank you. Our next question is from Daniel Ives from Wedbush Securities. Your line is now open.
Hi. This is Strecker Baki for Dan Ives. And our question is based on your conversations with customers, are you seeing an inflection point with larger scale security deployments in the field? Thanks.
I see more multiple solution integrate together to deploy. Yes, we do see some kind of deal get larger and because when you have a multiple solution integrate automate together, that you can I'm not sure that's a trend or not, it's still too early to say, Like our bigger deal or the bigger customer like at over $1,000,000 deal, the size got bigger, the number not quite grow flat. But I do see the deployment study need to be more integrated, more kind of a multiple solution working together now.
Yes. And I would just kind of kind of spot on and I would just kind of remind people that oftentimes we see staged deployments with our large enterprises. And so you will see some of these deals appearing from a single customer, they may be buying in Q2, Q3 and then again in Q1 or something like that. So I think it's difficult to look at individual customer because of the it's more than 1 quarter and offer a comment on that. But yes, the enterprise does drive larger deal sizes, whether that's just because of the number of firewalls or it's because of the fabric products that are being attached to it.
Yes. I think also we believe we have a huge advantage because most of our fabric products are internally organic designs from day 1, the designs work together, integrate together and also including some networking function like SD WAN compared to some other company that will purchase some of this product solution, which always very difficult for the integration and our office take time to make them working together. So we have huge advantage. So we do see the benefit got bigger and bigger now.
Great. Thanks for the color guys.
Thank you.
Thank you. Our next question is from Rob Owens from KeyBanc Capital Markets. Your line is now open.
Great. Thanks for taking my question. As you guys are clearly in share gain mode, especially given the product success that you're seeing, what's the competitive response been? What's the pricing environment like?
We don't have any price pressure right now. So that's why we're keeping feel the gross margin can keep improving, because one of the key differentiator is we are the only one design ASIC chip. Now we visit like close to 4,000,000 48 gig deployed and also the economy of scale starting working, whether the 2 sided effect, the more we deploy, they can also lower the average cost for the chip and also design cost average per chip. And at the same time, customers see more benefit, we can invest more in there. But like ASIC chip, it take a long time, 5 to 10 years to see the benefit.
So far none of our competitor been able to invest early enough to get in the space to see the benefit we have. So once we have a bigger and bigger number of unit deployment market share, we also see the accelerated benefit will help us to keep the differentiate advantage more. I think that's pretty much.
I guess, second, with regard to it being the September quarter, and I apologize if I missed this in the prepared comments, but any discussion around the Fed? It seemed like you had decent success in that vertical as well.
Yes. I think the all of our U. S. Government vertical, which is the vertical that we previously disclosed, had a good quarter. We are pleased with it.
And I do think that there was a little bit of, I think the U. S. Had part of that business, which again is a subset of our total vertical, did well in the quarter.
Thanks.
Thank you. Our next question is from Melissa Franchi from Morgan Stanley. Your line is now open.
Okay, great. Thanks for taking my question. A question for Ken or Keith. Just wondering if you can maybe comment on what you're seeing in terms of sales cycles. So on one hand, it seems like it's a very healthy security demand environment.
You're seeing good refreshes. But on the other hand, you're now selling a broader suite with the security fabric and that might require a broader rethink of the security architecture. So just wondering if that's creating maybe a little bit of elongation in the sales cycle?
I agree. It's very good point. We do see a customer take a little bit long time when they consider multiple solution, multiple product need to be working together. But also that's going to make the deal also larger. And also we have to train both our sales force and partner how to sell multiple product and make it all working together as a fiber solution is a very good point trend for this kind of refresh cycle.
Yes, I think we feel very good about the sales cycles. I mean, there is again, because we have success in both the SMB, the channel, the carrier as well as the enterprise, looking at the numbers for the quarter, I don't think that elongated sales cycle was the issue. I certainly do see us building things in our pipeline that are, I guess, I would call longer term or perhaps larger dollars, but those are much further out.
Okay, great. And then just one quick follow-up for you, Keith. You mentioned the contract durations this quarter was up just a little bit year over year, I think 1 month. How should we think about how that trends for Q4? And then any visibility into 2019 from a contract duration perspective?
Yes. I think, not something I would normally guide to, let's say, and I think previously I've talked about the year that we would expect that contract term would tick up during the year. And I think that's probably going to continue on through the Q4.
Got it. Thank you very much.
Thank you. Our next question is from Gregg Moskowitz from Cowen. Your line is now open.
Okay. Thank you very much. First question for you, Keith. This quarter, 40 day billings grew very well and they continue to hover around 75% of total. And I know that you're not yet providing guidance for next year, but just from a high level, how should we be thinking about the mix for FortiGate versus non FortiGate over the next 12 months or so?
Well, I think if I look back over the last for this year at least, that is pretty much kind of hovered in that similar mix, if you will. We are very pleased with the FortiGate fabric platform, and we will certainly continue with that as a key point of our strategy throughout 2019.
The non FortiGate grow a little bit faster than the FortiGate, but interesting with now we offer SD WAN within the FortiGate, we started getting to some infrastructure solution deployment, which have the security design in. So that actually will help in the FortiGate side. So we are not quite sure what's going on. But definitely we see the non FortiGate so far this year they grow faster than the FortiGate. But SD WAN may change in this a little bit.
But overall, we do see this will also bring additional service and also make the total solution better, stronger and because there's multiple solution or with the customers also make it more stickier with the customer.
Okay. That's helpful. And then Ken, how should we be thinking about the timing of the next ASIC product cycle for Fortinet?
I'd say it's pretty close. I think it will be within the next few months or few quarters. It's very close now. About every quarter we do refresh some of the product like some of the middle range, some of the and also we do have a last year we have what we call CP9 come out last year, which is improving the SSL encryption quite a lot. It's more like a 15x improvement.
So that's a huge advantage when you try to deploy the cloud access, so working beautifully both on the cloud and on the edge.
Okay. Terrific. Thanks very much.
Thank you.
Thank you. Our next question is from Michael Curtis from Raymond James. Your line is now open.
Hey, guys. Michael Turits from Raymond James. Thanks very much. Ken, for you, back to the cycle question, there is some concern about a fall off in IT spending overall into 2019. Are you starting to see anything that would suggest any hesitancy in terms of buying as people exercise some caution regarding the macro economy?
Yes. They do have a little bit concern in the last couple of months, but we don't see the security. Security within IT spending is still keeping increase. So even the IT spending is flat, we do see the security $2,000,000,000,000 market as because security get more and more $2,000,000,000,000 market as because security got more and more important for all the business we're doing here, all connect together and also past additional like IoT, OT security and past the cloud some other part. We do see the overall security spending is not decreasing, but keeping similar pace in the last like 20 some years.
Okay. Thanks. And then, Keith, can you talk a little bit about the specific things that you've been doing in the channel and in the field in general in order to help move for net upmarket? I know that you had talked about increases in incentives to sales a little while ago. Can you be specific about where you are with that as well as what you're doing in the indirect channel?
Yes, but a lot of credit goes to the sales team, I think, for their execution, together with the support from the marketing team and the R and D team. So I'm not sure that's if you're asking about comp plan specific, I think we talked previously that we did create a separate commission element for products in the Q2. I think more importantly and specifically with comp plans, one thing we did in the U. S. At the beginning of this quarter is we actually took the next step and separated the SMB business from the enterprise business in terms of how those compensation plans work and who's responsible for it.
And I would say I was ecstatic with the results on both ends of the spectrum. The SMB channel in the U. S. Did extremely well and the enterprise in the U. S.
Did extremely well too. I think there's just those teams performed extremely well. We got a little lift in productivity probably from that. And as we've talked before that I expect I don't see us separating the company, but I do see us continuing with our focus and how we go to market in these different segments and continuing to invest in
both. Our next question is from Brad Zelnick from Credit Suisse. Your line is now open.
Excellent. Thanks so much for taking my question. And I'll just say that I continue to hear great things in the field about the security fabric message and the product offering as well your SD WAN product sounds like it's really gaining great traction. But my and it's easy to see why you're gaining share in the market as a result of that. But my question is actually around security fabric on Azure, which can you mentioned in your prepared remarks.
And I know it's only about a month or so ago that you announced the expansion of that offering to include more of the fabric components. I'm curious, and again, I know it's early, but can you maybe comment a bit about how you see customers embracing your offering versus the native capabilities within the Azure platform itself such as Azure Firewall Service for example?
I think we have the approach more like a hybrid solution and that's where like a customer has the freedom whether deploy the appliance on their premise or some data application go to the cloud. For the Azure, the same thing, we have also the broadest security cloud offering, whether on Azure, on AWS, on some other like Google, Oracle, IBM, some other cloud. So that's where we want to offer the broadest, the best solution, which customer can select how to best fit their need and also offer the flexibility to transfer between changing between whether on premise and also on the cloud. So that's different compared to some of the native cloud provider offers some of the security service, which they're more focusing certain application only. It's not based on the networking side or the infrastructure side.
So that's where we are not competing with them. It's more like a different layer of security. So we're more on the infrastructure layer on the network side and on a compared they are most focus on certain application.
I appreciate that color, Ken. And for Keith, in your prepared remarks, you talked about the impact of tariffs on certain aspects of the results. And I think intra quarter, you might have commented on this publicly. But can you just spell out for us exactly what the situation and exposure is to China trade tariffs? Thanks.
Yes. The headline would be it'll be less in Q4, it'll be less than $300,000 of impact, probably significantly less. And in Q1, for the January 1 date, it will be less than $500,000 on a quarterly basis to COGS.
Excellent. Thanks so much guys.
Yes. Thank you.
Thank you. Our next question is from Ken Talanian from Evercore ISI. Your line is now open.
Hi, guys. Thanks for taking the question. I was wondering if you could rank your success in the enterprise by geo and then separately by vertical?
I think I'd comment just getting a little specific, I'd probably go back to the comments I made a moment ago that I thought the U. S. Did exceedingly well in the enterprise segment of the business in the Q3. And I'm really, really pleased with what they did. But I think going to the next level of detail is probably where I would pause.
Okay. And I guess you mentioned folks are making multiple purchases over time. Are you booking but not invoicing deals? And does that essentially give you some more visibility into future results?
I'd still put that more as a pipeline discussion, if you will. It just moves closer and closer to the close rate, but I'm not sitting on a large backlog, if that's the question.
Okay, great. Thanks.
Thank you. Our next question is from Walter Pritchard from Citi. Your line is now open.
Thanks. Just a quick question, follow-up on an earlier question on the long term deferred.
Can you
help us understand maybe how much of that is macro related to customers feeling better about budgets and how much of that is a factor of the mix into the enterprise? And in terms of what could drive that to go higher, what would be the drivers from here? It sounds like that's your expectation.
Yes. I think that if you look at enterprise this is Keith, I'm sorry. If you look at what I'll call the incumbents in the enterprise, you're probably seeing contract terms that are closer to 3 years. We're obviously at 26 months, as I noted. To the extent that we continue to have more and more success in that enterprise segment of the market, I would expect that their buying pattern, and I think we've talked about this before, is such that they're going to want to do 3 year contracts, and in many cases, they're going to want to 5 year contracts.
So I think that's where the pressure comes from. It's lined up with the success of the push into the enterprise.
And then can you comment on the fabric around things like endpoint and email? You haven't mentioned those. It sounds like it's been SD WAN and switching and so forth and wireless, but how are those products
doing? Things are growing very strong and it's a part of the fiber solution. We do see a similar growth. It's a pretty good growth.
I think Mail specifically I'm trying to check my numbers real quick. I think Mail had a very good quarter. I would just put that in the tier right below access, which is analyzer and access set point switches and analyzers.
Yes. But also the endpoint and also the SIEM and also the acquisition we have for the ZoomFactor also will help in endpoint and for the SIM growth.
Great. Thank you.
Thank you. At this time, I'm showing no further questions. I would like to turn the call back over to Peter Salkowski, Vice President of Investor Relations, for closing remarks.
Thank you, Gigi. I'd like to thank everyone for joining the call today and let you know that management will be presenting at the following technology conferences during the Q4. I will be at the UBS Conference here in San Francisco on November 12, the NASDAQ Conference in London on December 4, and then back to San Francisco for a December 6 conference with Barclays. We look forward to seeing all of you at those conferences. If you have any follow-up questions, please feel free to give me a call or send me an email.
Have a great rest of your day. Thank you very much.
Ladies and gentlemen, thank you for your participation in today's conference. This concludes the program. You may now disconnect.