Good day, ladies and gentlemen, and welcome to the Fortinet Incorporated Second Quarter 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 be given at that time. As a reminder, this conference is being recorded. I would now like to turn the conference over to Peter Salkowski, Vice President of Investor Relations.
You may begin.
Thank you, Sonia. Good afternoon, everyone. This is Peter Stolkowski, Vice President of Investor Relations at Fortinet. I'm pleased to welcome you to our call to discuss Fortinet's financial results for Q2 of 2018. Speakers on today's call are Ken Zee, Fortinet's Founder, Chairman and CEO and Keith Jensen, CFO.
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 forward guidance outlook before opening up the call for questions. During the Q and A session, we ask that you please be aware of the limited time we have for this call and make your questions brief to allow others to participate. Before we begin, I'd like to remind you that we will be making forward looking statements on today's call.
These forward looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those projected in these statements. Please refer to our SEC filings, in particular, the risk factors in our most recent Form 10 ks and Form 10 Q for more information. All forward looking statements reflect our opinions only as of the date of this presentation, and we undertake no obligation and specifically disclaim any obligation to update forward looking statements. Also, all references to financial metrics that we make on today's call are non GAAP unless otherwise stated. Our GAAP results and GAAP to non GAAP reconciliations can be found in our earnings press release and 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 thanks to everyone for joining today's call to discuss our Q2 2018 results. I'm pleased with our strong second quarter results. Buildings increased 20% year over year to 530,000,000 dollars while total revenue was up 21 percent to $441,000,000 Product revenue growth accelerated to 17% in the quarter. Non GAAP operation margin was 21.1%. We post non GAAP earnings per share of $0.41 and were profitable on a GAAP basis with earning per share of $0.28 We are experiencing strong global demand for our broad integrated and automated security fabric offerings due to the digital transformation and the network security refresh cycle that is occurring across most industries.
The competitive advantage of our security fabric architecture coupled with our cloud offering and customer for the ASIC technology are contributing to market share gains. We expect to continue to deliver above market growth balanced with profitability. Last week, we announced a new breadth of offering within the Google Cloud Platform that provide multiple layer of security from our next generation firewall to web application security and analytics. Additionally, fabric connectors are now available on the Google Cloud Platform, enabling the organization to apply consistent policy across multiple instance with one click integration. Fortinet now offers the broadest set of security offering of any security vendor on the Google Cloud, Microsoft Azure and AWS platforms.
Fortinet FortiGate received its 5th recommended rating in a row from NSS Lab next generation firewall testing, blocking 100% of the evisions and achieving an overall security effectiveness reaching of 99.3%. In the test, FortiGate also achieved the best performance for SSL inspection, thereby delivering the most compelling SSL ready cloud secure access. Fortinet continued to gain significant traction in the SD WAN marketplace and Fortinet is the only security vendor that provide a unique combination of next generation firewall and SD WAN in a single integrated offering. Customer around the global has chosen Fortinet for their secure SD WAN solution including a 7 figure win during the quarter with Super Union, a European based supermarket purchasing operation that represents over 1500 grocery store with a combined market share of almost 30% of the DASH market. This competitive win was against a large networking company.
During the quarter, Fortinet increased its IoT security offerings with the acquisition of Bradford Networks. The integration of Bradford Networks technology with Fortinet Security Fabric provide large enterprise with the continuous visibility, micro segmentation and access control technology that they need to contain threat and block and trust device from accessing the network. Our customer and the partner response to the Braford acquisition has been extremely positive and we look forward to leveraging Braford's technology with our customer base as well as introducing Fortinet product to the Braford customers. Our recent development approved that Fortinet remain focused on solving our customer pricing security need and helping them drive their digital transformation. We are excited about a sizable opportunity that lie ahead to feel above industry growth in this significant and growing total addressable market.
We will continue to invest while remain focused on improving operation margin as we work towards our goal of achieving our long term operation margin target of 25% by 2022. I want to thank the Fortinet team and our partner for their ongoing hard work and our customer for their support. Now I will turn the call over to Keith for a closer look at our Q2 performance and our Q3 and full year 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 periods unless stated otherwise. In the Q2, our better than market revenue growth rate drove strong bottom line results and strong free cash flow. I'm very pleased with the 2nd quarter results and believe we are well positioned to outpace the market for the rest of the year. Our infrastructure fabric offerings continue to resonate well with existing and new customers.
We have a strong industry leadership position due to our focus on delivering an innovative and high performing infrastructure fabric product portfolio. Our product portfolio claims are supported by independent recommendations from NSS Labs and appearances in Gartner Magic Quadrants, including a leader quadrant for both enterprise and UTM firewalls. We remain committed to balancing above market growth and improving profitability. And as Ken mentioned, achieving our non GAAP operating margin goal of 25% by 2022. Now for our Q2 results, starting with revenue.
Revenue grew 21% to 441,000,000 Total revenue in the quarter included a $5,200,000 benefit related to the ASC 606 accounting change. Excluding this benefit, total revenue growth would have been 20%. We expect the accounting change to have a similar impact on revenue for the remainder of 2018. Product revenue growth accelerated to 17%, resulting in product revenue of $166,000,000 Product revenue included a $4,200,000 benefit from the change in accounting relating to certain software licenses. There was no benefit from the accounting change related to product shipments.
Excluding the software license benefit, product revenue growth would have been a strong 14%. FortiGate unit shipments increased 18% and unit shipments of all products FortiGate and non FortiGate products combined increased 25%. Services revenue growth continued at 25% and totaled $275,000,000 Forticare, our traditional support offering increased 29% to $116,000,000 and FortiGuard, a security subscription offering increased 21% to $147,000,000 Regarding revenue predictability, as was the case in the Q1, about 60% of total revenue came from our existing deferred revenue balances. In the Q3, we expect a similar percentage of our total revenue to come from our existing deferred revenue balances. Deferred revenue increased 27% to $1,500,000,000 in the quarter and average contract length increased 2 months to 26 months.
Long term deferred revenue as a percentage of total deferred revenue increased 3 points year over year. As you can see on Slides 56, we remain a geographically diversified business. 2nd quarter revenue from the Americas represented 43% of our business. EMEA represented 37% and APAC represented 20%. Each region experienced strong revenue growth with EMEA, APAC and the Americas up 27%, 20% and 18% respectively.
Turning now to billings. 2nd quarter billings grew 20% to $513,000,000 As a reminder, the accounting change has no impact on billings. Each region experienced strong billings growth with the Americas, EMEA and APAC up 22%, 20% and 17% respectively. Consistent with the strong Americas billings performance, 6 of our top 10 the majority of our top 25 customer billings were with U. S.
Enterprise customers. 1 of the top billings in the quarter was a mid 7 figure competitor displacement with a large U. S. Metropolitan School District. In order to lower future operating expenses and increase network performance, the district chose Fortinet's products and services.
These included 6,000 series products and multiple security fabric products including advanced threat protection and sandboxing. Another significant enterprise success was winning a deal with a large U. S. Multinational financial services firm. This bank on the firewall vendor whose products integrated with other security products, a great use case for our security fabric platform.
We won the deal over 2 incumbents and a third enterprise firewall company. While the initial 7 figure billing was in the 2nd quarter, we expect additional 7 figure billings to occur in future quarters as the customer transitions to Fortinet. Slide 7 shows our billings mix by product family. As we have mentioned before, product level billings may not be the best way to represent the growth in our enterprise and SMB or channel segments. For example, a large enterprise will often deploy a significant number of mid level and entry level products into their distributed network.
While this is an enterprise customer, the buildings would not be included in the high end product family. As another data point, I would note a subset of our enterprise customers, specifically our global Forbes Global 2000 customers excluding carrier, we saw billings growth in the Q2 of 24% and trailing 4 quarter average billings growth of 30%. With this in mind, I should offer we expect to transition away from providing billings by product family if we are comfortable that we have data to share that we believe you will find more meaningful in evaluating our results and guidance such as billings by customer class. Network security billings accounted for slightly less than 3 quarters of total billings and were up 15%. Non FortiGate billings accounted for slightly more than a quarter of total billings and were up 33%.
Within non FortiGate, infrastructure fabric and cloud continue to experience significant growth rates at 41% 49% respectively. Cloud billings of our top 5 public cloud providers continue to experience triple digit growth. Regarding billings by vertical, service providers and MSPs continue to be the largest vertical accounting for 19% of billings up 1 point year over year. The number of deals over 250,000 pardon us for a moment. The number of deals over 250,000 grew 35%, driven by a 51% increase in deals over 500,000.
Illustrating the strength of our network security business among medium sized companies. Meanwhile, the number of deals over $1,000,000 were up 20% demonstrating continued growth in our enterprise business. Moving through the income statement, I'd like to remind you that all numbers I mentioned will be non GAAP unless stated otherwise. Our 2nd quarter gross margin increased 60 basis points to 75.4%. Product gross margin was down 1.9 points to 56.5 percent due to product and geo mix as well as product transitions.
Services gross margins expanded 1.4 points to 86.8%. Our total gross margin remains strong and growing due to the continued revenue mix shift to higher margin more predictable services. Net of commission benefit, total operating expenses increased 16.1% to $240,000,000 Total headcount in the 2nd quarter was up 14%. Operating margin of 21.1% was up 300 basis points year over year and 3.40 basis points sequentially. Operating margin benefited from a number of items including revenue growth and uptick in sales productivity and the benefit of the accounting change.
Offsetting these items was a negative impact of foreign exchange of $3,400,000 or 80 basis points. The accounting change benefited the 2nd quarter operating margin by 3 70 basis points with deferred commissions accounting for 2 70 basis points and the rest coming from the software revenue benefit referred to earlier. Please refer to the last slide in the earnings slide deck posted on our Investor Relations website for a line by line comparison of our non GAAP results and our non GAAP results excluding the adoption of ASC 606. We expect the Q3 and full year operating margin benefit from ASC 606 to be around 3.50 basis points. The 4th quarter ASC 606 benefit is expected to be about 300 basis points as the commission benefit related to ASC 606 is fairly linear in total dollar on a total dollar basis even in the quarter of seasonally higher revenue.
Net income for the Q2 was $71,000,000 or $0.41 per share based on 173,500,000 shares outstanding. As expected, the non GAAP effective tax rate was 24%. Moving to cash flow and capital. Cash flow from operations was $142,000,000 consistent with last year. Free cash flow was $131,000,000 up 124 percent year over year.
Excluding real estate purchases in the prior year, free cash flow declined 3 points. Capital expenditures in the 2nd quarter were $12,000,000 We expect 3rd quarter capital expenditures to be between $20,000,000 $25,000,000 Construction of the second building at our headquarters site is expected to start in the Q4. We estimate 2018 spending for this project to be between $10,000,000 $20,000,000 occurring mostly in the Q4. Total capital expenditures for 2018 are expected to be between $75,000,000 $90,000,000 In June, we paid approximately $17,000,000 in cash to acquire Bradford Networks, augmenting our Internet of Things or IoT security offerings. In the Q2, we repurchased 27,000 shares of our net stock for approximately 1,500,000 bringing the year to date totals to 2,500,000 shares 117,000,000.
This compares to the first half of twenty seventeen when we repurchased 848,000 shares for $33,000,000 On July 20, the Board approved a $500,000,000 increase in the share repurchase authorization bringing the total authorization to 1,500,000,000 and extended the term to the end of 2019. We believe share repurchases are a good method of returning value to our stockholders and expect to repurchase shares opportunistically. As I turn to guidance, 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 Q3, including the benefit of ASC 606, we expect billings in the range of $500,000,000 to $515,000,000 revenue in the range of $445,000,000 to 4 55,000,000 dollars non GAAP gross margin of 75% to 76%, non GAAP operating margins of 21.5% to 22% and non GAAP earnings per share of $0.41 to $0.43 which assumes a share count of between $175,000,000 $177,000,000 For 2018 full year including the benefit of ASC 606 we expect billings in the range of $2,085,000,000 to $2,110,000,000 Revenue in the range of 1,770,000,000 dollars to $1,790,000,000 non GAAP gross margin of 75% to 76%, non GAAP operating margin of 21.2% to 21.7 percent and non GAAP earnings per share of $1.63 to $1.67 which assumes a share count of between $174,000,000 $176,000,000 Slide 11 contains a summary of our guidance for the Q3 and the full year.
Before I turn the call back over to Peter, I'd like to thank our partners, our customers and the Fortinet team including our newest additions from the Bradford network for all their support and hard work. I'll now hand the call back over to Peter.
Thank you, Geese. We're ready, operator, to open the question and answer session. So if you could start that, that'd be great. Thank you.
Thank Our first question comes from Shaul Eyal of Oppenheimer. Your line is now open.
Thank you. Good afternoon, guys. Congrats on results and guidance. Ken, in your prepared remarks, you've mentioned an SD WAN deal with a sizable European supermarket chain. SD WAN, without a doubt, is a topic that came frequently in our field work on Fortinet.
When I'm correlating that to your accelerating product revenue for the remainder of 2018, can you talk to us about the SD WAN opportunity that Fortinet is seeing out there?
Yes. We started develop SD WAN technology few years ago and even like 4, 5 years ago, our core company related to this space. And that's fully integrated into the FortiOS, FortiGate product and also keeping enhancing that. That's we're making Fortinet as the only vendor combined SD WAN with security together. It's a huge advantage compared to the multiple box solution right now in the market with other competitor, other vendor there.
So that's where the customer feedback is very, very good. It's a huge advantage easy to manage cost saving and have the full security and I see flexibility and manageability there. So that's the example showing is a lot of customer see the huge advantage we have and very interest in this market we believe is a huge opportunity for us.
Understood. And maybe if I may, maybe attacking your things from the cloud perspective and the way that Fortinet looks at the cloud opportunity. So I know you've also mentioned NSS Labs. I believe that if you look at the SSL opportunity, I think companies such as NFS Labs, maybe some others are predicting that probably about 70%, 80% of all traffic will be encrypted by 2019, 2020. How does that fits with what Fortinet is doing on the cloud front?
Thank you.
Yes. This is a great question because a lot of companies started moving the data to the cloud. So we make the broadest offer for all the function and also very deep in the cloud. But one key area for the cloud, really how to secure access to data. So that's where like I said, it is a 7%, 80% of traffic need to be encrypt.
So that's where doing the testing on the next gen firewall testing. One key function need to be test is really the SSL encryption, which most cloud access using that encryption to the access especially on the mobile and some other device. So we have on average probably 10x the performance compared to any other vendor. It all benefit from the 4,008, which we developed the technology from the day 1 when we started the company. So we do believe a lot of security function they need to use in hardware accelerate because security function is a heavy computing.
Without acceleration it's a big impact on the performance, big impact of the CPU and other function. So that's where when we're testing the next gen firewall performance enabled SSL or disable SSL, we don't see much performance change compared to other vendor. It's a big drop on the performance and that's make us the SSL encryptions like on average more than 10x much better than any other competitor. Plus the box is very secure. We read about 100% efficient test, 99% on other testing there.
It's really the best perform, the most cost efficient and secure access from the cloud solution for the customer. So that's really the benefit from the ASIC chip from the early development we invest into this technology.
Thank you so much. Well done.
Thank you.
Thank you. Our question comes from Fatima Boolani of UBS. Your line is now open.
Good afternoon. Thank you for taking the questions. One for Ken and one for Keith, if I may. Ken, just around some of the opportunities that you're seeing on the Wi Fi side, that's an area that you haven't really talked about in a little bit. So I just wanted an update with respect to the product portfolio there, some of the competitive dynamics in the marketplace and sort of traction you're seeing there?
And then a follow-up for Keith.
Yes. I think it's interesting, we talk about the fabric grow faster than the 40 ks, the non 40 ks faster than the FortiGate grow like 33%. Actually among the non FortiGate, the security access that's including the most of the company on the WiFi and also some we call the FortiSwitch has the fastest growing area, which grows triple digit. Because we believe the vision few years ago the Wi Fi management just like SD WAN they need to be combined with security and that's a huge advantage if we can integrate it together. So more and more customers, better enterprise customers see the need.
And that's making this an integrated solution. It's a huge benefit to the customer. We still like compared to some other like Wi Fi opportunity, we still are relatively small. So that's give us huge opportunity going forward because we are also the only provider can combine Wi Fi and security together into a single OS and single platform. So that's where a huge benefit for the enterprise.
Otherwise, they have to have 2 different management system and separate policy for security and Wi Fi which is a big burden for the lot enterprise IT guy. So that's also the benefit of the fabric. With the fabric we can cross quite a broad attack surface to match together from the traditional security to the endpoint and to the management and to the Wi Fi to the SD WAN. So making the fabric storage fabric approach is a very attractive tool to a lot of customers, especially enterprise customers.
That makes a ton of sense. And Keith, I want to drill into the guidance and sort of the optimism that you're sort of baking into the guidance as we think about the full year. Can you help us understand some of the assumptions and sort of the dynamics you're seeing that's playing into sort of the back half and how the year is going to play out with respect to your guidance? That's it for me. Thank you.
Yes. I think we're seeing tailwinds that are coming with the product refresh cycle that we're going through on our side with the new E series is resonating extremely well, particularly in the mid enterprise market. I think we would look to some recent CIO surveys by various analysts that speak to a tailwind that's coming from IT spending. I look at the pipeline, the quality of the pipeline, I'm seeing a strong quality of the pipeline as we look forward. I'm seeing the deal sizes increase in the pipeline.
I look at things like tenure and productivity. I look at what was a very high level of execution by the sales and marketing group in the second quarter and the movement into the continued movement into the enterprise space. And I think all those things are leading up to Comfort.
Thank you.
Thank you. And our next question comes from Gabriela Borges of Goldman Sachs. Your line is now open.
Good afternoon. Congratulations on the quarter, either for Ken or Keith. I wanted to spend a little more time on the product revenue growth number that 14 percent year over year normalized for 606. Maybe you could just comment on a couple of things. One is, how much does that benefit from ASP or mix?
I noticed that the percentage of billings coming from higher end products was up a little bit. And the other two comments just on refresh rate and win rates on new business, How do those three things play in together to get to the 14% number? Thanks.
Yes. So the last question first? The refresh, I mentioned refresh cycle this time compared to the last time is about 4, 5 years now, last time is 20 12, 2013. But this is different than last time. There's no big news.
It's not a rush by pattern. It's a long evaluation and also making the refresh cycle probably last longer than last time. That's actually played well for us, because we have a quite broad product and also integrate well together. So that's really give the customer chance to evaluate even the buying decision take longer time. But like I said, we see the number the bigger deal to be increased and also the last 12 months especially enterprise growth in the last 12 months, like on average over 30%.
So that's actually pretty well for us in this refresh cycle.
Yes. I would just Ken spot on Gabriela. I would just add a couple of things. Maybe a little bit of the question is trying to get the guidance on product revenue going forward. And as you know, we don't guide to it.
But I can offer a couple of things that I think are coming into play. One is we did change our comp plans for a small group of people here in the quarter to further incent them to focus on product revenue growth. And I think we certainly saw that come forward. I think the other data point I would offer is that when we look at the quality of billings in the 1st month of the quarter, Q2 versus Q3, And again, keep in mind that the 1st month with our linearity is a fairly small sample size. We're seeing Q3 starting to shape up along the lines of Q2, but it's very early on.
That's helpful. And follow-up if I may on the midterm model at the Analyst Day we talked about a 15% to 20% revenue growth number. You're right up at the upper end of that now when I look at the guidance and when I look at what you did in the quarter. How sustainable do you think that 20% -ish revenue growth number is? Is there a scenario where you could actually be at that for a little while?
And Keith, if you could just clarify how much did Bradford Networks contribute to the revenue in the quarter? Thank you.
Yes, good questions. I'll take them in reverse order. Bradford Networks 34 employees, you can probably project from there. But I would also offer it was in the 6 figures for billings and revenue for the quarter. And in terms of growth, I think we're obviously very comfortable with the model that we presented at the Analyst Day in February.
And I think we'll continue to perform against that model throughout this year. It would be a logical time probably in the Analyst Day next February to see with the benefit of Q3 and Q4 what we'd like to start talking about for midterm and long term model at that point. I think the other aspect of it is the enterprise growth rate. Obviously, we're very, very pleased with what we're seeing there and we'd like to see a few more quarters of that coming online as well.
Makes sense. Thank you.
Thank you. Our next question comes from Jonathan Ho of William Blair. Your line is now open.
Hi. Let me echo my congratulations on the strong quarter. You mentioned that the security fabric integrating with other products was an important reason why customers chose Fortinet. Can you maybe give us some more color into maybe why that is and why it's an important differentiator just given the breadth of partners that you have?
I think like I even we hosted Analyst Day early this year, the enterprise customer liking the fabric a lot. That can help them lower the total operation cost, especially the management cost, because there's too many different security product in enterprise developed by different vendor, which is not quite integrate or automate together. So that's where we see the benefit of our in house developed, very broad portfolio of the product and integrate working together, especially for the enterprise customer. Like I said, in the Analyst Day, we still have less than half of the customer or the partner be able to train or to sell multiple product, which we were keeping developing, keeping training. Actually the other number I can give you already compared to 1 years ago, the number of people trained up in certified on the NIC, the network security expert almost doubled.
So we're continuing to develop and we're hoping once the more partner or the customer or even our own internal sales force in train on this multiple product approach will keep increase the multi product selling in the fabric selling. And also fabric because it's a multi component also making more sticky and add a long term value bigger, make the deal bigger. And that's a win win situation for both outside and also for the customer and for the partner.
Got it. Got it. And then just to talk about some of the strength in the quarter, I mean, it looked like the EMEA region was particularly strong even though all the regions seem to do pretty well this quarter. Can you maybe give us some sense of what drove the strength in EMEA?
I think EMEA has historically done well for us. So I don't I'm not shocked by it. Always very pleased with their execution. I do think they're getting some tailwind from GDPR. I think they're getting some opportunities with some competitive displacements.
I think that we've given them a good product suite now in the low end and mid range that are resonating very well.
Thank you.
Thank you. Our next question comes from Sterling Auty of JPMorgan. Your line is now open.
Hey, guys. This is actually Ugam Kamath on for Sterling. Keith, in your prepared remarks, you mentioned that the contract duration actually went up by 2 months. Is it something where you are seeing customers coming in and planning to extend their contracts so that they can lock in Fortinet for a longer time? Or is it because your sales people are really trying to increase the duration for hitting their like accelerators on commission given the change in the compensation plan?
Yes.
I think that's the fair way of asking the question. I think that we've made some changes in our price list as well as our compensation plans that impact the terms of contracts. Is there some of that going on? Sure. But I don't think it's as significant as it once was.
You repeat the beginning of the question. I'm sorry, somebody just nudged me on something else.
Yes, Simon.
I think as you push into the enterprise, I think it's very natural, particularly if you look, say, the example we gave a large bank in the U. S, those are sticky implementations. The customer knows that they're not going to be in a hurry to rip and replace. So I think as we and I said this before, as we continue to see growth in the enterprise, we'll continue to see that product segment coming with longer contract terms.
Okay. And one on the presentation that you put out on Slide 11, if I see that, you are comparing the billings for 3Q and full year 2018 being compared to the billings of 2017, but they are on like 606 for 2018 versus 605 for 2017. I mean, I know I mean it couldn't like change in accounting standard would not impact it much, but since we are just doing it on a calculated basis, did the accounting rule have any particular effect on that growth rate that you have on the slide level? No.
The accounting change has no impact on billings.
Perfect. Thank you.
Thank you. Our next question comes from Keith Bachman of Bank of Montreal. Your line is now open.
Hi, good afternoon. My first question, I just wanted to ask you on product gross margins. They were down a decent amount. I didn't hear anything in prepared remarks, but perhaps I missed it. Why were product gross margins down?
Hi, Keith. This is Keith Jensen. I don't think that we guide on product gross margins, but we do guide on total gross margins. And I think you'll notice that total gross margins were up. So I think you can assume that we saw that met our expectations, both the change in services and product.
We did see a shift in our mix a little bit. As I alluded to earlier, our E Series is doing extremely well in the low end and the high end. And when you have a product transition, there's some costs associated with that.
Okay. And did the M
and A you took on this quarter impact that maybe a little bit too on the product gross margin?
No. It was as I said, it was low 7 figures for total revenue and split between hardware and software.
Yes. The high end product, we like the 6000, 7000 series we launched early this year will take a longer sales cycle, both on the hardware and the software evaluation. The high end tend to have a little bit higher margin. And also like Keith mentioned, when the service turn extend 2 months, that also has some impact of the product margin.
Got it. Got it. Okay. My follow-up question then deals with cash flow. If we look at the start of the year versus today, some of the CapEx has obviously been pushed out.
And it sounds like more of the real estate will actually show up in what would be calendar year 2019. Is there any just notional amount you want us to think for real estate in 2019? And then B, just run rate CapEx, seems like the run rate now is call it $50,000,000 around about away from real estate. Is that a fair way to think about it? Or is there even variability in that 50,000,000 dollars characterization?
And that's it for me. Thank you.
I don't I think it's you should not see on the run rate significant changes, large changes, if you will, from quarter to quarter. We're not, say, a data centric, data center centric company that's building out large data centers. We don't have a lot of upfront tooling costs with our products. Over the longer term, you should see it pretty much aligned with headcount drives it. As you open up new offices, as you expand new offices, talking about leases now, of course there's some improvements to be made that sort of thing that are kind of bumping around a little bit, but I don't think of the magnitude that should give you concern.
Okay. Okay. And then just any characterization on real estate next year, just order of magnitude, how should we should be thinking about it?
I'm just pausing, because we don't guide to free cash flow, we don't guide to real estate. I think the probably thing that we probably want to come back to that in the Q3 timeframe and give you something on that. But generally speaking, you shouldn't be shocked that the construction project, the timing slips that you get through city approvals and environmental issues and so forth. So some of that benefit you're seeing in Q in 2018, all things being equal, to show up in 2019 assuming no delays in construction.
Okay, understood. Many thanks.
Also the real sticky was a much more benefit compared to some of our cost competitor, which we pretty much on the lease and both on the dollar and the percent in whites, probably half or less than half of compared to competitor. That's direct contribute back to the shareholder earning all these things. And at the same time, give us some flexibility can have the facility built for long term need, especially for certain R and D for certain infrastructure side. And that's a it's already most of the real estate investment we made already paid back and also it's a long term benefit for company going forward.
Okay. All right. Thank you.
Thank you. And our next question comes from Walter Pritchard of Citi. Your line is now open.
Yes. Hi. Jarrod Bensard in for Walter. I've got several questions around the large banks deal that you referred to in the prepared remarks. I guess, can you talk to roughly how large you anticipate the deal to be once fully deployed?
And is it fully booked? And then how does that factor into your full year guide? I have a follow-up.
Yes. I guess the bad news is I'm not going to disclose the total deal value, but I could offer that yes, it is in our guidance. It's part of our guidance as an input. But what you typically see with the larger enterprises is a deployment schedule. And so you would not expect it to see all of it in any one quarter.
We really don't have a concept of bookings as you refer to it. If we get a purchase order under a contract, we'll ship the product and then you'll see it in billings.
Okay, got it. And then I just had a question on traction in enterprise. It sounds like business is improving. Can you maybe talk about any changes you're seeing in the competitive landscape? And then can you walk us through the driving factors in some of the larger enterprise wins?
Yes. We have a reputation as a very good product, but probably a little bit less investing in the marketing and also the coverage of the enterprise sales also compared to our competitor also a little bit less. So we kind of study more focused on enterprise. We feel it's expanding from some of the channel advantage we have. So you can see the last 12 months, the enterprise side growth has an average of 30%.
It's probably like as compared to some of our competitor, this is market growth even come from maybe smaller base. But we do see the opportunities big and also that's also we're starting to also invest a little bit more on the marketing side, which also help in the enterprise growth. So that's and then the fabric message and also helping from the technical level there. I think that all this combined we do see the enterprise as a big potential for us or probably the biggest growth factor for us going forward. So we'll continue to invest both in the sales marketing side and also leverage the technology advantage we have especially in the fabric in the performance of ASIC.
So we see it's a very good potential in enterprise growth going forward.
Yes. And I would just add to that. I would reiterate 2 of Ken's comments. I think the total cost of ownership and the outstanding performance of the product give us a clear advantage. I think the other two items just to emphasize would be 1, the Gartner Magic Quadrant, which we were in the leadership for about a year now.
And we've actually timed that market fairly well with some normal renewals that are going on with some competitors. So I think we're gaining certainly gaining traction with that. And I think also the NSS Labs recommendations, the success that we're having there with our technical buyers are working very well. The last comment I would offer on that in terms of the opportunity that Ken is referring to, when we look at the penetration numbers in terms of that Global 2,000, I'm not going to disclose that number, but that's what drives us to say that we have seen clear success in that segment of the market and we see there's significant opportunity for more success in that segment.
Yes. Also the product release timing also working well. So with the high end and also some of the middleware starting releasing now that also gave us more advantage even add additional advantage over competitor especially in the enterprise
space. Okay, helpful. Thank you.
Thank you. Our next question comes from Melissa Franchi of Morgan Stanley. Your line is now
open. Hi, good afternoon. This is Hamza Fodderwala in for Melissa Franchi. Looks like the enterprise metrics looked really good, but it seems like the mix of the low and medium range appliances is going up the most. And I'm just wondering, does this imply that there's a refresh happening more at the branch?
And has there been any changes in the competitive landscape there?
Yes, I would this is Keith. I would point you to the descriptions that we modified in the pie charts that speak to product family growth. And again, I would emphasize what we see with our enterprise customers is they're buying to for the entire tax surface, which includes them purchasing low end and mid range products. And that's why it's looking at product family, I think is a somewhat flawed approach. And one of the discussion points that we're having internally and I related to is that perhaps others are more interested in our buildings by customer class and then a logical follow on question would be okay now you know who the customers are, what are they buying.
We seem to have kind of jumped in the second step and that's a reflection of something we'd like to start talking about in the future.
Also from the sales force angle, we try to see what's the channel driven or partner driven and what's the like direct touch and also some of the VAR, I think that's where we're starting tracking a little bit different and that's what we're making this enterprise or channel driven is the split is probably better fit into the space.
And on the cloud billings, they were particularly strong in recent quarters. Is that largely selling into the existing base appliances or is it entirely additive?
I think the additive and especially we see the top 5 top infrastructure cloud,
I think
they grow probably triple digit. So that's where we see a good potential in the cloud and also we offer very broad product function without the cloud provider and keeping investing in this area.
Okay. Thank
you. Thank you. Our next question comes from Gary Powell of Deutsche Bank. Your line is now open.
Great, thanks. Maybe just a couple of quick ones, if that's okay. So at an industry level, how do you feel about the pace of appliance revenue growth in 2018 versus 2017? Do you see it picking up? And then how do you see that trending over the next couple of years particularly as virtual form factors become more meaningful?
I think the virtual form whether like in the private cloud or in the hybrid or public cloud will add on top of the appliance. I don't think the impact of the appliance sales, because the whole infrastructure security, which need to be both with the cloud and also with on premise and with our plans together. And also some other like fabric approach, whether the SD WAN, the Wi Fi, all these edge security, they do need a plan there to make it even working with cloud together. So that's where we don't see the virtual, the cloud has impact of the it's really in some degree even helping our plant sales, especially all these branch office sales, which we have also huge advantage. I think the refresh cycle definitely will help in like I said the refresh cycle starting like this year will help in the next couple of years compared to last year or the year before.
So that's we see is a good opportunity for us.
Okay. Okay. And then just to follow-up. I mean, I know you guys touched on this in a prior question, but I'm going to ask it anyway. So I mean, if I back out the accounting issues, looks like product revenue growth jumped from about 1% in Q1 up to 14% in Q2.
So it's just kind of a big increase, little unusual. How sustainable is double digit product growth?
And I think this is Keith. And I think you've done the math exactly correctly. That's the good news. As I suggested a moment ago, we made some changes to comp plans. Number 1, with a select group of key decision makers inside the team, which seem to create some tailwind for it.
I think we also are seeing very broad and robust acceptance of the new E Series product that have started in the low end and in the mid range. And I would believe that would create tailwind. And then again, when I looked at just the 1st month of this quarter versus the 1st month of last quarter, and even though that's a small sample size given linearity, I think the indications are strong. I think the other aspect to look at is that, 2 other aspects. This is the Q3 now that we've talked about unit shipments and this time we talked about 18% unit shipments and that's in the range of prior quarters.
And then 25% when you count in the fabric or non FortiGate products. So you're seeing those fabric product shipments also show up in the product revenue line as well providing more tailwind.
Got it. Okay, that's helpful. Thank you very much.
Thank you. Our next question comes from Andrew Nowinski of Piper Jaffray. Your line is now open.
Hey guys, great quarter and thanks for the question. You guys talked about SD WAN is having a good quarter and we've had some prior questions already. There's a competitor of yours making a lot of noise in the space around securing SD WAN and partnering with pure play SD WAN providers. I guess first, is the go to market of this through managed service providers? And second, how often is SD WAN essentially leading in deals compared to Fortinet security solutions?
Like I said, we're only vendor combined SD WAN with security together and been doing that for the last few years. And then we do see a lot of opportunity and SD WAN actually helping open quite some other opportunity, which when they try to do the new infrastructure deployment, SD WAN is a requirement that also give us an advantage of leading to some of the deal. So that's where is a big benefit for us. But also going forward we do see the advantage. We have combined SD WAN security together.
And also the other thing is ready with our Forti ASIC keeping additional performance boost. So that's making a solution not only flexible with SD WAN networking side, but also much better performance compared to some of our other competitors. And that you can see the branch office, all this growth is starting showing quite a lot of number there.
Got it. And then Keith not to beat a dead horse here, but kind of based on my math here for revenue, it looks like guidance essentially product declining sequentially about 8%, which is well below normal seasonality. Just is it you wanting to be kind of conservative on the model here? Or is it did you have any pull forward of product revenue into the quarter?
Yes, again we don't guide to product revenue, but I think if you look at it sequentially, you might look at it a little bit differently that way and have a different perception on it.
Thank you. And our next question comes from Rob Owens of KeyBanc Capital. Your line is now open.
Great and thanks for taking my question. Leveraging Gray's strong math skills from earlier and I guess, getting the product revenue numbers, this is the best performance you've seen in quite a while. And Ken, you spoke to a refresh cycle through the E Series. And I guess, is this occurring within your own I
think
the
I think we do refresh our product every few years with whether the new ASIC, the new CPU or some other better networking technology. The E series most starting from the low end and then the middle end and then the high end early this year gave us some of the benefit, but refresh do not finish yet. It's only probably half or around half there and we'll continue to get a new middle range or some other high end since come out. And I think each new generation is compared to this year definitely have a big improvement on the performance and better interface and all the things there. But on the other side, the refresh cycle I mentioned also help.
That's the industry wide compared to the last 4, 5 years ago, the whole industry rush by or whatever. Now it's the time to refresh because the hardware whether the networking or the server whatever after 4, 5 years they need to be upgraded. So that's opened up a lot of opportunity especially in some enterprise. We probably not play that much in the enterprise last time, but now we see the opportunities that open up for us. And at the same time, the fabric also play quite well with enterprise customer.
Great. Thanks for the perspective. And then second, if I compare your non GAAP 605, I guess, operating margin result, it was actually down on a year over year basis about 70 basis points. And over the last couple of quarters, the benefit from 606 and deferral of commissions has been far greater than I think anticipated or what you had articulated in the rough guidance. So as we two questions.
Number 1, why was it down on a year over year basis? And then secondarily, as we look at your margin targets for the year, how much of that is a lift from 606 at this point?
Yes. So when you look at operating margin year over year, I think you have to keep in mind that that was Q1, Q2 of last year, we were under hiring significantly. And you probably saw that throughout Q1 and Q2. So those year over year comparisons are a little tough. I think for example, 1 quarter last year, the operating margin went up 5 points quarter to quarter sequentially.
So that's a little tough to execute each and every time. And I think I refer back to the comments in terms of the benefit from 606 and I'll take it in 2 pieces. 1, the software revenue benefit, which is a reflection of software revenue growth for certain licenses, that growth has caught me by surprise, I'll admit to that. And that's about one point of benefit to margin. Last quarter, we talked a lot about U.
S. Hardware unit shipments and what was happening with the channel there. There was no benefit from that in the current quarter. And I think I mentioned at the time that we had a target in mind of how many weeks of inventory we wanted to have. We pretty much hit that in Q1 and we kept it through Q2.
I would expect that to settle out at no change, if you will. On the commissions benefit side, I think the history of that is or where we're ending up is with a couple of quarters under our belt now, we have pretty good visibility to it. Did we undersell a little bit in the beginning because of the complex accounting change? Sure, probably we are conservative. But this 2.50 basis points, 2.70 in the current quarter, that appears to be a fairly good number at these revenue numbers.
As that revenue increases, that benefit declines slightly, which you'll see in the 4th quarter.
So I threw a
lot at you, happy to follow on if you want.
Great. Thank you.
Thank you. And our next question comes from Brad Zelnick of Credit Suisse. Your line is now open.
Really appreciate you guys taking my question. I wanted to follow-up on an earlier question on cash flow, which I think was more focused on real estate and what to expect going forward. But even if we and know there's always lumpiness quarter to quarter on cash flow, but if we adjust for real estate and just look to the adjusted numbers that you give us, it's down year on year in the quarter. How should we think about cash flow for the year and what the puts and takes might be as it relates to this quarter and going forward?
Yes. I think when you look at the good question, Brad. When you look at the year over year comparison, went back and looked and what we really saw was the large inventory adjustment in our model came into play Q1 to Q2 of last year. And I want to say that was in the $20,000,000 range. And if you look at our inventory levels since then, they've been fairly constant.
So there was kind of a one time benefit for inventory of about $20,000,000 previously. I don't see myself dropping inventory not with these hardware revenue growth rates by $20,000,000 So I think that's probably the large item. And after that, it was some cats and dogs, cash for taxes year over year was up $3,000,000 payables and so forth. But there wasn't anything other than that inventory change, there really wasn't something noteworthy.
Got it. And just if I could follow-up, if I look at the mix of product and services, you're clearly benefiting nicely from the mix shift to higher margin services. But while you incentivize product growth in the quarter, it seems services was more in line at least with street models, not that we all know how to model your business. But even if I look at it seasonally, services is below the quarter on quarter growth that we saw Q1 to Q2 in the last couple of years. How much of this is a sign of just decelerating product in the last few quarters sort of catching up and maybe not providing as much attach opportunity?
How much of it might be a sign of stronger contribution from refresh? Can you maybe just parse through a little bit the puts and takes and how it drives the services line?
The services line is a very predictable number. It comes pretty much as I said in the comments, 60% of it comes from deferred revenue and deferred revenue was up 27% year over year to 1.5 $1,000,000,000 We do provide disclosures breaking down services revenue between FortiCare and FortiGuard. But again, both of those had very strong revenue growth. I think the other thing to keep in mind is services revenue since it's coming off the balance sheet from deferred, that's a lagging indicator as opposed to a more current growth metric would be billings, which is not something that we provide.
I appreciate it. Thank you, Keith.
Thank you. And ladies and gentlemen, this does conclude our question and answer session. I would now like to turn the call back over to Peter Sakhowski for any further remarks.
Thank you, Sonia. I'd like to thank everyone for joining the call today and let you know the management will be presenting at the following technology conferences during the Q3 will be at the Oppenheimer Conference in Boston on August 7, the Citibank Conference in New York on September 5, and the Deutsche Bank Conference in Las Vegas on September 12. We look forward to seeing many of you at 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.
Ladies and gentlemen, thank you for participating in today's conference. This concludes today's program. You may all disconnect.