Good day, ladies and gentlemen, and welcome to the Fortinet, Inc. 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. If anyone should require operator assistance, please press star then zero on your touchtone telephone. 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 Salkowski, Vice President of Investor Relations at Fortinet. I'm pleased to welcome you to our call to discuss Fortinet's financial results for the second quarter of 2018. Speakers on today's call are Ken Xie, 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&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 for 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, and particularly the risk factors in our most recent Form 10-K and Form 10-Q for more information. All forward-looking statements reflect our opinions only as of the date of this presentation, and we undertake no obligation and specifically disclaim any obligation to update forward-looking statements. 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 accompany 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 to this call to discuss our second quarter 2018 results. I'm pleased with our strong second quarter results. Billings increased 20% year-over-year to $513 million, while total revenue was up 21% to $441 million. Product revenue growth accelerated to 17% in the quarter. non-GAAP operating margin was 21.1%. We post non-GAAP earnings per share of $0.41 and were profitable on a GAAP basis with earnings 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 custom 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 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 fifth recommended rating in a row from NSS Labs next-generation firewall testing, blocking 100% of the evasions and achieving an overall security effectiveness rating of 99.3%. In the test, FortiGate product 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. Fortinet is the only security vendor that provide a unique combination of a 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 seven-figure win during the quarter with Superunie, a European-based supermarket purchasing organization that represent over 1,500 grocery store with a combined market share of almost 30% of the Dutch 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 untrust device from accessing the network. Our customer and partner response to the Bradford acquisition has been extremely positive.
We look forward to leveraging Bradford's technology with our customer base, as well as introducing Fortinet product to the Bradford customers. Our recent development proved that Fortinet remain focused on solving our customer pressing security need and helping them drive their digital transformation. We are excited about a sizable opportunity that lie ahead to fuel above industry growth in this significant and growing total addressable market. We will continue to invest while remain focused on improving operating margin as we work towards our goal of achieving our long-term operating 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 on our second quarter performance and our third quarter and full year guidance.
Thank you, Ken. Before I start, I would 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 second quarter, our better-than-market revenue growth rate drove strong bottom-line results and strong free cash flow. I am very pleased with the second 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 the 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 second quarter results, starting with revenue. Revenue grew 21% to $441 million. Total revenue in the quarter included a $5.2 million 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 million. Product revenue included a $4.2 million 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 million. FortiCare, our traditional support offering, increased 29% to $116 million, and FortiGuard, our security subscription offering, increased 21% to $147 million. Regarding revenue predictability, as was the case in the first quarter, about 60% of total revenue came from our existing deferred revenue balances. In the third quarter, we expect a similar percentage of our total revenue to come from our existing deferred revenue balances. Deferred revenue increased 27% to $1.5 billion in the quarter, and average contract length increased two months to 26 months. Long-term deferred revenue as a percentage of total deferred revenue increased three points year-over-year. As you can see on slides five and six, we remain a geographically diversified business.
Second 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. Second quarter billings grew 20% to $513 million. 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, six of our top ten and the majority of our top 25 customer billings were with U.S. enterprise customers. One of the top billings in the quarter was a mid-seven-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 6000 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 wanted a firewall vendor whose products integrated with other security products, a great use case for our Security Fabric platform. We won the deal over two incumbents and a third enterprise firewall company. While the initial seven-figure billing was in the second quarter, we expect additional seven-figure billings to occur in future quarters as the customer transitions to Fortinet. Slide seven shows our billings mixed 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 billings 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 Forbes Global 2000 customers, excluding carrier, we saw billings growth in the second quarter of 24% and trailing four-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 three-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 continued to experience significant growth rates at 41% and 49% respectively. Cloud billings of our top five public cloud providers continued to experience triple-digit growth. Regarding billings by vertical, service providers and MSPs continued to be the largest vertical, accounting for 19% of billings, up one 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 million 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 mention will be non-GAAP unless stated otherwise. Our second quarter gross margin increased 60 basis points to 75.4%.
Product gross margin was down 1.9 points to 56.5% 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 million. Total headcount in the second quarter was up 14%. Operating margin of 21.1% was up 300 basis points year-over-year and 340 basis points sequentially. Operating margin benefited from a number of items, including revenue growth, an uptick in sales productivity, and the benefit of the accounting change. Offsetting these items was a negative impact of foreign exchange of $3.4 million or 80 basis points.
The accounting change benefited the second quarter operating margin by 370 basis points, with deferred commissions accounting for 270 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 third quarter and full-year operating margin benefit from ASC 606 to be around 350 basis points. The fourth quarter ASC 606 benefit is expected to be about 300 basis points, as the commission benefit related to 606 is fairly linear on a total dollar basis, even in the quarter of seasonally higher revenue. Net income for the second quarter was $71 million, or $0.41 per share, based on 173.5 million shares outstanding.
As expected, the non-GAAP effective tax rate was 24%. Moving to cash flow and capital, cash flow from operations was $142 million, consistent with last year. Free cash flow was $131 million, up 124% year-over-year. Excluding real estate purchases in the prior year, free cash flow declined three points. Capital expenditures in the second quarter were $12 million. We expect third-quarter capital expenditures to be between $20 million and $25 million. Construction of the second building at our headquarters site is expected to start in the fourth quarter. We estimate 2018 spending for this project to be between $10 million and $20 million, occurring mostly in the fourth quarter. Total capital expenditures for 2018 are expected to be between $75 million and $90 million. In June, we paid approximately $17 million in cash to acquire Bradford Networks, augmenting our Internet of Things, or IoT, security offerings.
In the second quarter, we repurchased 27,000 shares of Fortinet stock for approximately $1.5 million, bringing the year-to-date totals to 2.5 million shares and $117 million. This compares to the first half of 2017, when we repurchased 848,000 shares for $33 million. On July 20th, the board approved a $500 million increase in the share repurchase authorization, bringing the total authorization to $1.5 billion, 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 third quarter, including the benefit of ASC 606, we expect billings in the range of $500 million-$515 million, revenue in the range of $445 million-$455 million, non-GAAP gross margin of 75%-76%, non-GAAP operating margins of 21.5%-22%, and non-GAAP earnings per share of $0.41-$0.43, which assumes a share count of between 175 and 177 million. For 2018 full year, including the benefit of ASC 606, we expect billings in the range of $2.085 billion-$2.110 billion. Revenue in the range of $1.770 billion-$1.790 billion. Non-GAAP gross margin of 75%-76%. Non-GAAP operating margin of 21.2%-21.7%. non-GAAP earnings per share of $1.63-$1.67, which assumes a share count of between 174 and 176 million.
Slide 11 contains a summary of our guidance for the third quarter 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 Networks, for all their support and hard work. I'll now hand the call back over to Peter.
Thank you, Keith. We're ready, operator, to open the question and answer session. If you could start that, great. That'd be great. Thank you.
Thank you. Ladies and gentlemen, if you have a question at this time, please press star then one on your touchtone telephone. If your question has been answered or you wish to remove yourself from the queue, please press the pound key. To prevent any background noise, we ask that you please place your line on mute once your question has been stated. As a reminder, we ask that you please limit yourself to one question and one follow-up. Any additional questions, please reenter the queue. 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 products 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 to develop SD-WAN technology a few years ago, even four or five years ago, acquired a company related to this space. That's fully integrated into the FortiOS and FortiGate product, also keeping enhancing that. That's where making Fortinet the only vendor combining SD-WAN with security together is a huge advantage compared with the multiple box solution right now in the market with the other competitor, other vendor there. That's where the customer feedback is very, very good, is a huge advantage, easy to manage, cost-saving, and have the full security and SD-WAN flexibility and manageability there. That's the example showing it's a lot of customer see the huge advantage we have, and they're very interested in this market. We believe it's a huge opportunity for us.
Understood. Maybe for me, maybe attacking the thing from the cloud perspective and the way that Fortinet looks at the cloud opportunity. I know you've also mentioned NSS Labs. I believe that if you look at the SSL opportunity, I think companies such as NSS Labs, maybe some others, are predicting that probably about 70%-80% of all traffic will be encrypted by 2019, 2020. How does that fit with what Fortinet is doing on the cloud front? Thank you.
Yeah, this is a great question. 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. One key area for the cloud, really how to secure access the data. That's where, like I said, is 70%-80% of traffic need to be encrypted. That's why we're doing the testing on the next-gen firewall testing. One key function need to be tested is really the SSL encryption, which most cloud access using that encryption to the access, especially on the mobile and some other device. We have, on average, probably 10x the performance compared to any other vendor. It all benefits from the FortiASIC, which we developed the technology from day one when we started the company.
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 on the CPU and the other function. That's where when we're testing the next-gen firewall performance, enable the 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 make the SSL encryptions, on average, more than 10x, much better than any other competitor. Plus the box is very secure. We read about 100% evasion test, 99% on other tests in there. It's really the best performed, the most cost efficient, and secure access from the cloud solution for the customer. 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 next 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. A follow-up for Keith.
Yes, I think, it's interesting we talk about the fabric grow faster than the FortiGate. The non-FortiGate grow faster than the FortiGate, grow like 33%. Actually, among the non-FortiGate, the secured access, that's including the most is come from the Wi-Fi and also some we call the FortiSwitch, has the fastest growing area, which grows triple digit. Because, we believe the vision a 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. More and more customers, especially enterprise customers, see the need. That's making this an integrated solution. It's a huge benefit to the customer. We still, compared to some other Wi-Fi opportunity, we still are relatively small, so that give us huge opportunity going forward.
We are also the only provider can combine Wi-Fi and security together into a single OS and single platform. That's making the FortiGate can be also the Wi-Fi controller, manage all the AP together with security, with all the Wi-Fi traffic. That's where a huge benefit for the enterprise. Otherwise, they had to have two different management system and separate policy for security and the Wi-Fi, which a big burden for a lot of enterprise IT guy. That's also the benefit of the fabric. With the fabric, we can cross quite a broad attack surface to mesh it together from the traditional security to the endpoint and to the management and to the Wi-Fi, to the SD-WAN. Making a fabric story, fabric approach is very attractive to a lot of customers, especially enterprise customers.
That makes a ton of sense. Keith, I wanted 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 the back half, and how the year's going to play out with respect to your guidance? That's it for me. Thank you.
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. The continued movement into the enterprise space. I think all those things are leading up to comfort.
Thank you.
Thank you. 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% year-over-year normalized for 606. Maybe you could just comment on a couple of things. One is, how much did that benefit from ASP or mix? I noticed that the percentage of billings coming from higher end products is up a little bit. 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.
Yeah. Can answer the last question first. The refresh, I mentioned refresh cycle this time compared to the last time, it's about four, five years now. Last time is the 2012, 2013. This time different than last time, there's no big news. It's not a rush-bu y pattern. It's a long evaluation and also making the refresh cycle probably last longer than last time. That actually play well for us because we have a quite broad product and also integrate well together. That's really give the customer a chance to evaluate. Even the buying decision take longer time, but like I said, we see the number, the bigger deal keeping increase and also the last 12 months, especially enterprise growth in the last 12 months, like on average over 30%. That's actually play well for us and in this refresh cycle.
Yeah. Ken's spot on, Gabriela. I would just add a couple 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. I can offer a couple 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. 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 first month of the quarter, Q2 versus Q3, and again, keep in mind that the first month with our linearity is a fairly small sample size.
We're seeing Q3 starting to shape up along the lines of Q2, it's very early on.
That's helpful. Follow-up, if I may, on the midterm model. At the Analyst Day, we talked about a 15%-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? Keith, if you could just clarify, how much did Bradford Networks contribute to the revenue in the quarter? Thank you.
Yeah, good questions. I'll take them in reverse order. Bradford Networks, 34 employees, you can probably project from there. I would also offer it was in the six figures for billings and revenue for the quarter. In terms of growth, I think we're obviously very comfortable with the model that we presented at the Analyst Day in February. 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 would like to see a few more quarters of that coming online as well.
Makes sense. Thank you.
Thank you. Again, ladies and gentlemen, if you have a question at this time, please press star then one on your touch-tone telephone. 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?
Yeah, I think that, even we hosting Analyst Day earlier this year, the enterprise customer like in the Fabric a lot. That can help them lower the total operation cost, especially the management cost. There's too many different security product in enterprise, developed by different vendor, which not quite integrate or automate together. That's where we see the benefit of our in-house developed, very broad portfolio of the product can integrate working together, especially for the enterprise customer. Like I say, 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, compared to one years ago, the number of people trained or been certified on the NSE, the Network Security Expert, almost double.
We're continuing to develop, we're hoping once the more partner or the customer or even our own internal sales force being trained on the multiple-product approach, will keep increase the multi-product selling, the Fabric selling. Also Fabric, because it's multiple product, also make it more sticky and add long-term value bigger, make the deal bigger. That's a win-win situation for both outside and also for the customer and for the partner.
Got it. Just to talk about some of the strength in the quarter, it looked like the EMEA region was particularly strong, even though all the regions seemed 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, 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 the mid-range that are resonating very well.
Thank you.
Thank you. Our next question comes from Sterling Auty of J.P. Morgan. Your line is now open.
Hey, guys, this is actually Ugam Kamat on for Sterling. Keith, in your prepared remarks, you mentioned that the contract duration actually went up by two months. Is it there's something where you are seeing customers coming in and planning to extend their contract so that they can lock in Fortinet for a longer time? Or is it because your salespeople are really trying to increase the duration for hitting their accelerators on commission, given the change in the compensation plan?
Yeah, I think that's a 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. I don't think it's as significant as it once was. If you can repeat the beginning of the question, I'm sorry, somebody just nudged me on something else.
Yeah.
I think as you push into the enterprise, I think it's very natural, particularly if you look, say, at the example we gave, the 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. 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. 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, they are on like ASC 606 for 2018 versus ASC 605 for 2017. I know it could change in accounting standard would not impact it much, 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 11?
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, perhaps I missed it. Why were product gross margins down?
Hi, Keith. This is Keith Jensen. Don't think that we guide on product gross margins, we do guide on total gross margins, I think you'll notice that total gross margins were up. 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.
Okay.
As I alluded to earlier, our E-Series is doing extremely well in the low end and the high end, when you have a product transition, there's some cost associated with that.
Okay, did the M&A you took on this quarter impact that maybe a little bit too, on the product gross margins?
No. As I said, it was low seven figures for total revenue and split between hardware and software.
Yeah, the high-end product like FortiGate 6000 series, 7000 series we launched early this year will take a longer sales cycle, both on the hardware, on the software evaluation. The high end tend to have a little bit higher margin. Also like Keith mentioned, when the service turn extend two months, that also have some impact of the product margin.
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, A, 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 about for real estate in 2019? B, just run rate CapEx. Seems like the run rate now is, call it $50 million around about away from real estate. Is that a fair way to think about it, or is there even variability in that $50 million characterization? That's it for me. Thank you.
You should not see on a run rate significant changes, large changes, if you will, from quarter to quarter. We're not a data center-centric company that's building out large data centers. We don't have a lot of upfront tooling costs with our products.
Right.
Over the longer term, you should see it fairly 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. Just any characterization on real estate next year, just order of magnitude, how 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 we probably want to come back to that in the Q3 timeframe and give you something on that.
Okay.
Generally speaking, you shouldn't be shocked that a construction project, the timing slips as you get through city approvals and environmental issues and so forth. Some of that benefit you're seeing in Q in 2018, all things being equal, will show up in 2019, assuming no delays in construction.
Okay, understood. Many thanks.
The real estate give us a much more benefit compared to some of close competitor, which we pay much on the lease and both on the dollar, on the percentage-wise, probably half or less than half of competitor. That directly contribute back to the shareholder earning all these things. At the same time, give us some flexibility, can have the facility built for long-term need, especially for certain R&D, for certain infrastructure side. Most real estate investment we made already pay back, also is a long-term benefit for company going forward.
Okay. All right. Thank you.
Thank you. Our next question comes from Walter Pritchard of Citi. Your line is now open.
Yeah. Hi, Jaron Bazarn 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 through roughly how large you anticipate the deal to be once fully deployed, and is it fully booked? How does that factor into your full-year guide? I have a follow-up.
Yeah. I guess the bad news is I'm not going to disclose the total deal value. I could offer that yes, it is in our guidance. It's part of our guidance as an input. What you typically see with the larger enterprises is a deployment schedule, 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. You'll see it in billings.
Okay, got it. 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?
Can you walk us through the driving factors in some of the larger enterprise ones?
We have a reputation as a very good product, but probably a little bit less invest in the marketing and also the coverage of the enterprise sales also, compared to our competitor, also a little bit less. We kind of are starting more focus on enterprise. We feel it's expanding from some of the channel advantage we have. You can see the last 12 months, the enterprise side growth as an average is 30%. It's probably like, compared to some of our competitor, this is market growth even come from maybe smaller base. We do see the opportunity is big and also that also we're starting also invest a little bit more on the marketing side, which also help in the enterprise growth. The fabric message and also helping from the technical level there.
I think that all this combined, we do see the enterprise has a big potential for us or probably the biggest growth factor for us going forward. We'll continually invest both in the sales marketing side and also leverage the technology advantage we have, especially in the fabric, in the performance from ASIC. We see it's a very good potential in the enterprise growth going forward.
I would just add to that, I would reiterate two 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, one, the Gartner Magic Quadrant, which we were in the leadership for about a year now. We've actually timed that market fairly well with some normal renewals that are going on with some competitors. I think we're certainly gaining traction with that. I think also the NSS Labs recommendation, 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's 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.
Yeah. Also, the product release timing also working well. With the high-end and also some of the middle we're starting releasing now, that also give us more advantage, even 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, it seems like the mix of the low and medium range appliances is going up the most. I'm just wondering, does this imply that there's a refresh happening more at the branch? Has there been any changes in the competitive landscape there?
This is Keith. I would point you to the descriptions that we modified on the pie charts that speak to product family growth. Again, I would emphasize what we see with our enterprise customers, is they're buying for the entire attack surface, which includes them purchasing low-end and mid-range products. That's why it's looking at product family, I think, is a somewhat flawed approach. One of the discussion points that we're having internally, and I relate it to, is that perhaps others are more interested in our billings 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 in the second step. That's the reflection of something we'd like to start talking about in the future.
Also, from the Salesforce angle, we try to see what's the channel driven or partner driven, and what's the like a direct touch and also some of the VAR. I think that's where we're starting tracking a little bit different, that's what making this enterprise or channel driven, the split is a probably better fit into the space.
Got it. On the cloud billings, they were particularly strong in recent quarters. Is that largely selling into the existing base of appliances, or is it entirely additive?
I think it's additive, especially, we see the top five public infrastructure cloud, I think they grow probably triple digit. That's where we see a good potential in the cloud. Also we offer very broad product function with all the cloud provider and keeping investing in this area.
Okay. Thank you.
Thank you. Again, ladies and gentlemen, if you do have a question at this time, please press star then one on your touchtone telephone. Our next question comes from Gray Powell of Deutsche Bank. Your line is now open.
Great, thanks. Maybe just a couple of quick ones, if that's okay. 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? 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 in the private cloud or in the hybrid or public cloud, will add on top of the appliance. I don't think it's any impact of the appliance sales. The whole infrastructure security, which need to be both with the cloud and also with on-premise and with our plans together. Also some other like fabric approach, whether the SD-WAN, the Wi-Fi, all these edge security, they do need appliance there to make it even working with cloud together. That's where we don't see the virtual or the cloud has. It's very, in some degree, even helping our appliance 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 this year will help in the next couple years, compared to last year or the year before. That we see is a good opportunity for us.
Okay. Just to follow up, I know you guys touched on this in a prior question, but well, I'm going to ask it anyway. If I back out the accounting issues, looks like product revenue growth jumped from about 1% in Q1 up to 14% in Q2. It's just kind of a big increase. A little unusual. How sustainable is double-digit product growth?
Yeah, this is Keith, 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 seemed 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. I would believe that would create tailwind. Again, when I looked at just the first month of this quarter versus the first 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 third quarter 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. 25% when you count in the fabric or non-FortiGate products. 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. Thanks for the question. You guys talked about SD-WAN as having a good quarter. 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? Second, how often is SD-WAN essentially leading in deals compared to Fortinet security solutions?
Like I said, we are only vendor combine SD-WAN with security together and been doing that for the last few years. 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 advantage leading to some of the deal. That's where it's a big benefit for us. Also, going forward, we do see the advantage, and we have combined SD-WAN security together. Also, the other thing is really with our FortiASIC keeping additional performance boost. That's making a solution not only flexible with SD-WAN network inside, but also much better performance compared to some of other competitors. That you can see the branch office, all this growth is starting showing quite a lot of number there.
Got it. Keith, not to beat a dead horse here, kind of based on my math here for revenue, it looks like guidance implies 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 did you have any pull forward of product revenue into the quarter? Thanks.
Yeah. Again, we don't guide to product revenue, 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. Our next question comes from Rob Owens of KeyBanc Capital. Your line is now open.
Great, thanks for taking my question. Leveraging Gray's strong math skills from earlier, I guess getting the product revenue numbers. This is the best performance you've seen in quite a while. Ken, you spoke to a refresh cycle through the E-Series, I guess is this occurring within your own installed base, or are you seeing this more network-wide, where you're seeing better customer acquisition through E-Series right now?
I think that 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 mid-range, and then the high end early this year, gave us some of the benefit, but the refresh do not finish yet. It's only probably around half there. We'll continue to get a new mid-range or some other high-end things come out. I think the Each new generation, this year compared to this year, definitely have a big improvement on the performance and a better interface and all the things there. On the other side, the refresh cycle I mentioned also help. That's the industry wide compared to the last four or five years ago, the whole industry rushed by or whatever.
Now is the time to refresh because the hardware, whether networking or the server, whatever, after four or five years, they need to be upgraded. 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 starting to open up for us. At the same time, the fabric also play quite well with the enterprise customer.
Great. Thanks for the perspective. Second, if I compare your non-GAAP 606, I guess, operating margin result, it was actually down on a year-over-year basis about 70 basis points. 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. Two questions. Number one, why was it down on a year-over-year basis? Secondarily, as we look at your margin targets for the year, how much of that is a lift from 606 at this point?
Yeah. When you look at operating margin year-over-year, I think you have to keep in mind that was Q1, Q2 of last year, we were under hiring significantly. You probably saw that throughout Q1 and Q2. Those year-over-year comparisons are a little tough. I think, for example, one quarter last year, the operating margin went up five points quarter-to-quarter sequentially. That's a little tough to execute each and every time. I think I refer back to the comments in terms of the benefit from 606, and I'll take it in two pieces. One, 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. 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 were conservative.
This 250 basis points, 270 basis points 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 fourth quarter. I threw a lot at you. Happy to follow on if you want.
Great. Thank you.
Thank you. 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. Even if we, and I know there's always lumpiness quarter-to-quarter on cash flow, if we adjust for real estate and just look to the adjusted numbers that you give us, it's down year-over-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?
Yeah. Good question, Brad. When you look at the year-over-year comparison, went back and looked, what we really saw was the large inventory adjustment in our model came into play Q1 to Q2 of last year. I want to say that was in the $20 million range. If you look at our inventory levels since then, they've been fairly constant. There was kind of a one-time benefit for inventory of about $20 million previously. I don't see myself dropping inventory, not with these hardware revenue growth rates, by $20 million. I think that's probably the large item. After that, it was some cats and dogs, cash for taxes year-over-year was up $3 million, payables and so forth. There wasn't anything, other than that inventory change, there really wasn't something noteworthy.
Got it. 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. 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. Even if I look at it seasonally, services is below the quarter-over-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, deferred revenue was up 27% year-over-year to $1.5 billion. We do provide disclosures breaking down services revenue between FortiCare and FortiGuard. 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. Ladies and gentlemen, this does conclude our question and answer session. I would now like to turn the call back over to Peter Salkowski for any further remarks.
Thank you, Sonia. 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 third quarter. We'll be at the Oppenheimer Conference in Boston on August 7th, the Citibank Conference in New York on September 5th, and the Deutsche Bank Conference in Las Vegas on September 12th. We look forward to seeing many of you at these 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.