Ladies and gentlemen, thank you for standing by, and welcome to the Fortinet fourth quarter 2019 earnings announcement. At this time, all participant lines are in a listen only mode. After the speaker's presentation, there will be a question and answer session. To ask a question during the session, you will need to press star then one on your telephone. Please be advised that today's conference is being recorded. If you require any further assistance, please press star then zero. I would now like to hand the conference over to your speaker today, Peter Salkowski. Please go ahead.
Thank you, Sarah. Good afternoon, everyone. This is Peter Salkowski, Vice President of Investor Relations at Fortinet. I'm pleased to welcome everyone to our call to discuss Fortinet's financial results for the fourth quarter and full year of 2019. Speakers on today's call are Ken Xie, Fortinet's founder, chairman, and CEO, and Keith Jensen, our Chief Financial Officer. This is a live call that will be available for replay via webcast on our investor relations website. Ken will begin our call today by providing a high-level perspective on our business. Keith will then review our financial and operating results, providing our guidance for the first quarter and full year of 2020 before opening the call for questions. During the Q&A session, we ask that you please keep your questions brief and limit yourself to one question and one follow-up question to allow others to participate.
Before we begin, I'd like to remind everyone that on today's call, we will be making forward-looking statements. These forward-looking statements are subject to risks and uncertainties, which could cause actual results to differ materially from those projected. Please refer to our SEC filings, in particular, the risk factors in our most recent Form 10-K and Form 10-Q for more information. All forward-looking statements reflect our opinions only as of the date of this presentation, and we undertake no obligation and specifically disclaim any obligation to update forward-looking statements. Also, all references to financial metrics that we make on today's call are non-GAAP, unless stated otherwise. Our GAAP results and GAAP to non-GAAP reconciliation is located 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, thank you to everyone for joining today's call to review our fourth quarter and full year 2019 result. We are pleased with our very strong fourth quarter performance. Billings increased 24% to $802 million, driven by solid execution and growth across each of our markets, EMEA and APAC. Revenue increased 21% to $614 million, with product revenue up 19% and service revenue up 23%. Non-GAAP operating margin was 27%. For 2019, billings increased 21% to $2.6 billion. Revenue was up 20% to $2.2 billion, Our non-GAAP operating margin was 25%. These strong results were driven by our advanced FortiGate technology with SPU and secure SD-WAN, our integrated security fabric platform, and hybrid multi-cloud offerings. Fortinet was recently named one of the top three vendors in the 2019 Gartner Magic Quadrant for WAN Edge Infrastructure.
Fortinet's security-driven networking approach to SD-WAN offer customers the most comprehensive solution with security and enterprise-grade networking capability integrated in a single box. Our unique approach has allowed us to gain significant market share over the past 12 months. With more than 21,000 companies using Fortinet Secure SD-WAN solution and 70% of top-tier service providers offer our SD-WAN solution, we are now the leading SD-WAN vendors. Today, we announced the release of FortiGate 40F, the most affordable next-generation firewall with secure SD-WAN. The 40F includes our new SoC4 security processor. The 40F delivers Security Compute Rating up 3 to 23 times faster than industry average appliances , which use generic CPUs. The traditional perimeter-based network security has expanded across the entire infrastructure to the wide area networks, including SD-WAN and 5G, and to the local area networks, including the Wi-Fi and internal segmentation.
Fortinet's ability to offer security-driven networking and high performance with our SPU technology are clearly competitive advantages. Going forward, we are working hard to ensure that Fortinet's three growth engine will help us grow faster than our competition and the market overall. First, we continue to gain market share in network security, driven by our SPU competitive advantage. Our SPU technology enables us to add cutting-edge security and network functionality, including SD-WAN, while maintaining strong performance despite network traffic continuing to increase. The introduction of the new FortiSPU , like SoC4 and NP7, as well as the first 40K product built with NP7 to be announced later this month, is expected to widen our competitive advantage. The second growth engine is our Security Fabric platform, including hybrid and multi-cloud deployment.
Unlike competitive platforms that bring together loosely integrated acquired solutions, Fortinet's Security Fabric, which from the very beginning was most developed internally, offer a broad, automated, and truly integrated security platform for end-to-end protection, making it easier for customers to consolidate to a few security vendors. Third, our engineer-focused culture of continuous innovation strongly positions Fortinet for long-term growth and competitive advantage. With at least three times the technology patents compared to our competition, Fortinet's IoT, OT, 5G, hybrid cloud, and edge solutions are leading the transition to the latest generation of cybersecurity. I want to thank the Fortinet team and our partners for their ongoing hard work and our customers for their support. Now I will turn the call over to Keith for a closer look on our fourth quarter and full year performance and to provide guidance for 2020.
Thank you, Ken. Let me first note that except for revenue, financial amounts are non-GAAP and growth rates are based on comparisons to the fourth quarter and full year of 2018, unless stated otherwise. The slide references I make refer to the presentation posted on our investor relations website. I'd now like to provide a summary of our strong fourth quarter performance and follow up on certain metrics from the Analyst Day. We believe the metrics we shared last November highlight our diversity by geography, customer size, industry segments, and solutions, as well as provide insights into our financial model. Let's start our fourth quarter review with revenue. Total revenue of $614 million was up 21%. Revenue growth was led by the fabric and cloud segments with over 30% growth, followed by network security growth at 18%.
Product revenue growth was 19%, or $239 million, benefiting from both legacy firewall use cases and consistent with Ken's SD-WAN commentary from continued adoption of our FortiGate-based secure SD-WAN solution. Simply put, our secure SD-WAN firewall use case combines in a single appliance, security with application-aware routing that can lower MPLS and other costs. The fourth quarter revenue growth of 19% was consistent with our strong third quarter performance, even when faced with a more difficult year-over-year comparison. We believe our product revenue growth may be among the highest in this network security industry. Moving to service revenue, our higher margin service revenue increased 23% to $376 million and represented 61% of total revenue, increasing 10 points in four years. FortiGuard security subscription revenue increased 24% to $205 million. FortiCare technical support and other service revenue increased 21% to $170 million.
Renewal rates remained consistent with prior periods and within the guidelines we provided at the Analyst Day. Deferred revenue at the beginning of the fourth quarter accounted for approximately 90% of service revenue. Revenue growth on a geographic basis saw the Americas up 23%, APAC up 22%, and EMEA up 19%. Before continuing with our fourth quarter results, I'd like to highlight our revenue performance for the year. Total revenue for the full year grew 20% to $2.2 billion. Product revenue grew 17%, service revenue grew 21% and represented 63% of total revenue. Returning to the fourth quarter with a focus on billings. Total billings increased 24% to $802 million. Network security product and service billings increased 20% and accounted for 73% of total billings. Illustrating the continued traction with our fabric platform and cloud strategies, non-network security billings increased 35%.
In Europe, we saw Germany perform better than planned, while in the U.K., billings declined. The U.K. decline appears related to Brexit distractions. We expect U.K. billings growth will return to positive territory in the current quarter. Looking at billings by verticals, service providers and MSSPs accounted for 18% of total billings. We experienced outpaced growth from government, financial services, retail, and education. As a follow-up to the Analyst Day, I would note the top 5 verticals again accounted for 65% of total billings. At year-end, total deferred revenue increased 27% to $2.1 billion. Short-term deferred revenue increased 22% to $1.2 billion. Looking now at deal sizes and illustrating our continued expansion in the enterprise market, deals over $1 million increased 36% to 64 deals.
Secure SD-WAN was a leading contributor to the increase in the number of deals in excess of $1 million, accounting for 10 deals in the quarter, up from four deals last year. With a reference to our diversification, we have now completed 11 quarters in a row without a single transaction representing over 2% of quarterly billings. The number of deals over $250,000 increased 29% to 469, and the number of deals over $500,000 increased 53% to 197. In the fourth quarter, our average contract term increased one month to 26 months. As we noted at the Analyst Day, Secure SD-WAN transactions include a greater mix of enterprise customers and somewhat longer contract terms. Moving back to the income statement. In the fourth quarter, gross margin improved 230 basis points to 78%. Product gross margin improved 400 basis points to 61.9%.
As you saw in the third quarter, product gross margin benefited from gains in average selling price, as well as lower direct unit cost and indirect cost. We are pleased with the product gross margin improvement we've achieved in each of the last two quarters. Services gross margin increased 90 basis points to 88.2%. Operating margin for the fourth quarter increased 110 basis points to 26.8%. The improvement in gross margin was partially offset by an increase in the pace of hiring, mostly in sales and marketing, lower sales attrition, and spending associated with recent M&A activity. For the full year, gross margin was 77.5%, up 150 basis points from 2018, benefiting from a 190 basis point improvement in product gross margin. For the full year, the operating margin was 24.5%, up 220 basis points from 2018.
Total headcount ended the year at 7,082, an increase of 21% from the end of 2018. The two fourth-quarter acquisitions increased headcount by 135. Excluding these two acquisitions, headcount would have increased 19%. Given the strong operating income performance, net income for the fourth quarter was $132 million, or $0.76 per diluted share. Net income for the full year was $432 million, an increase of 35%, resulting in earnings per diluted share of $2.47. On a GAAP basis, we reported full-year net income of $327 million, or $1.87 per diluted share. This represents our 11th consecutive year of GAAP profitability, a milestone we've been able to achieve every year since becoming a publicly traded company in 2009. Moving to the statement of cash flow summarized on slides 10, 11, and 12. Adjusted free cash flow for 2019 increased 28% to $776 million.
CapEx for the fourth quarter were $47 million, including $36 million on real estate spending. For 2020, CapEx are expected to be between $210 million-$240 million, which includes spending on the campus expansion. We expect first quarter total CapEx to be between $25 million and $35 million, again, including spending on the campus expansion. In the fourth quarter, we repurchased approximately 303,000 shares of our common stock for a total cost of $23 million. For the full year, we repurchased 1.9 million shares for a total cost of $141 million. At the end of the fourth quarter, the remaining share repurchase authorization was $1.6 billion, with a plan set to expire at the end of February 2021. Before wrapping up with guidance, I would like to offer information on two additional areas, our fourth quarter acquisitions, and also SD-WAN.
First, on the M&A side, we completed two technology and talent tuck-in acquisitions in late October and December. With a combined contribution to fourth quarter revenue of significantly less than 1%, these acquisitions pulled down fourth quarter operating margin by approximately one-half of a percentage point. We expect the impact from these acquisitions on first quarter and full year 2020 operating margins to be roughly a 100 basis point headwind. Second, our secure SD-WAN offering continues to be a point of differentiation for Fortinet. In the fourth quarter, secure SD-WAN billings represented high single digits of total billings. In 2019, for the full year, secure SD-WAN added about seven points to product revenue growth and represented mid to high single digits of total billings. On a full year basis, there were no significant changes to the year-to-date third quarter metrics for secure SD-WAN that we provided at the Analyst Day.
Service contracts continued to attach to the FortiGate at a rate consistent with other FortiGate use cases. Finally, new logos continue to account for approximately 50% of secure SD-WAN billings. Next, I'd like to review our outlook for the first quarter and full year 2020, summarized on slide 13, which is subject to the disclaimers regarding forward-looking information that Peter provided at the beginning of the call. For the first quarter, we expect billings in the range of $635 million-$655 million. Revenue in the range of $555 million-$565 million. Non-GAAP gross margin of 77.5%-78.5%. Non-GAAP operating margin of 19%-20%. Non-GAAP earnings per share of $0.50-$0.52, which assumes a share count of between 175 million and 177 million. We expect a non-GAAP tax rate of 24%.
As I begin to provide 2020 guidance, I'd like to remind everyone of the financial model expectations for the next three years that was provided at the November Analyst Day. For the period from 2020 through the end of 2022, we expect organic billings and revenue growth to be at least 15% for each of the next three years. In non-GAAP operating margin to average at least 25% during this three-year period. For 2020, we expect billings in the range of $3 billion-$3.075 billion . Revenue in the range of $2.525 billion-$2.555 billion . Total service revenue in the range of $1.635 billion-$1.655 billion . Non-GAAP gross margin of 77.5%-78.5%. Non-GAAP operating margin of 23.5%-24.5%.
While we estimate the recent acquisitions will be a 100 basis points year-to-year headwind to our 2020 operating margin included in the numbers above, we believe our operating margin over the next three years will average at least 25%. Non-GAAP earnings per share of $2.70-$2.73, which assumes a share count of between 180 million and 182 million. We expect our non-GAAP tax rate to be 24%. We expect cash taxes to be approximately $40 million. Along with Ken, I'd like to welcome the CyberSponse and again, the enSilo teams to Fortinet and thank our partners, our customers, and the Fortinet team for all their support and hard work. With that, I'll hand the call back over to Peter.
Thank you very much, Keith. Operator, we're ready to open up for Q&A, please.
Thank you. As a reminder, to ask a question, you will need to press star then one on your telephone. To withdraw your question, please press the pound key. Our first question comes from the line of Brian Essex with Goldman Sachs. Your line is now open.
Hi, good afternoon. Thank you for taking the question, and congratulations on some nice results. I was wondering, Keith, if maybe you could unpack the guidance a little bit. Coming in, particularly on the growth side of the equation, several hundred basis points over your at least 15% guide on the Analyst Day. Where does the confidence there come from, and what are some of the levers that could give us some comfort that there's the appropriate level of conservatism in that number?
Yeah, I think when you look at a longer-term model, you're probably looking more at Gartner growth rates in terms of what you expect to see from SD-WAN, what you expect to see in the network firewall, and what you expect to see in the fabric. I think the guidance is certainly within those ranges when you factor in our historical ability to outgrow the market. I think if you pull that in, particularly to, say, the first quarter or even the current year, it's much more based upon the pipeline. When we look at the pipeline and the opportunities that we see in the pipeline, it clearly supports the guidance that we've just provided.
Yeah. Also, we do increase the sales capacity with additional hiring in sales and marketing, which are close to 20% total headcount increase, will definitely help drive additional growth.
Got it. That's helpful. Maybe if I could follow up with a quick one on the current results for the quarter. Product revenue nicely strong in the high teens and services revenue as well during a quarter where maybe some of your peers found it a little more challenging to put up positive product revenue growth at the very least. How much did SD-WAN and Fabric contribute to each of those segments, and how might you view the overall spending environment for core firewall considering the results that you had? I did hear you comment on high single-digit SD-WAN contribution, if maybe you could paint a bigger picture of other contributing factors to those line items and the spending environment overall would be really helpful.
Yeah. I think for the network security, we believe we are gaining a lot of market share because the product architecture with our own ASIC, what we call SPU, has huge computing power, can keep adding whether security function or the networking function like SD-WAN. Even the product we announced today, that's from 3x to 23x more powerful than other competitor industry average. This will make us gaining market share. Also the SD-WAN market last year is about $1.5 billion and may grow 50% year-over-year in the next few years. We are now the leading vendor in SD-WAN with most of the customer and also most of the service provider also starting to adopt our SD-WAN solution. We do believe we're also gaining share in that space. That also will help us.
The Fabric, you can see almost double the network security growth because our Fabric is mostly internal developed and well integrated. It's more easy to up-sell, cross-sell once some product add in and because all the other part of Fabric working together quite well. That's where customers see the benefit of our consolidation. We see that's also a growth driver. There's a few other new technology we also pioneered, but that's probably more long-term, maybe still wait for a few more years to see more materialize. We do believe we'll be also leading some of the technology changing in the space.
Fantastic. Thank you very much.
Thank you.
Thank you. Our next question comes from the line of Brad Zelnick with Credit Suisse. Your line is now open.
Fantastic. I'll echo my congratulations. What a real strong finish to 2019 and impressive guidance as well. Ken, if I can ask you a question. As I look to competing SD-WAN solutions out in the market, I think there are some out there that take a different architectural approach in delivering it mainly as a cloud service. Aside from customer preference, can you maybe speak to the architectural trade-off of centering the functionality in the cloud versus delivering it as you do?
I think by moving some applications to the cloud, actually helping more deployment in SD-WAN, at the same time, even within the cloud, there's a few research actually, whether from the government, NSA, or come from academic, like CMU, that the cloud actually increase the security risk. That's where even within the cloud, you also need to secure the cloud itself. That's also helping what we call hyperscale, some other kind of approach to get inside networks, that's probably beyond the traditional SD-WAN side. That's where we do working with a lot of service provider, cloud provider, and make SD-WAN part of their total offering. We also understand sometimes they have their own business model with more supporting each other instead of more competing on each other. That's the ecosystem side working quite well for us.
Thank you. That's very helpful, Ken. Keith, if I could just follow up with a quick one for you. DSOs seem to be running a little bit hot. Can you comment at all on linearity? I mean, at the same time, you've obviously guided to a very nice Q1 and full year next year. Any color on the jump would be helpful. Thank you.
Yeah. I think the math at DSO, we picked up about a day from the acquisitions, and that pretty much puts us back in line with what you would expect normally. I would offer my experience in high tech on the Christmas holiday season is always very busy. I don't think Fortinet's unusual.
Fair enough. Thank you so much.
Thanks, Brad.
Thank you. Our next question comes from the line of Melissa Franchi with Morgan Stanley. Your line is now open.
Thank you for taking my questions, and congrats on a solid quarter. Ken, it looks like you're seeing good growth in large deals and in multimillion-dollar deals, and I know that you said that SD-WAN is a leading contributor to strength there, but I'm just wondering if you could provide more color on what those deals look like. Is it your existing customers that are refreshing at the branch, or are you displacing some competitor solutions and you're coming in because of the SD-WAN capability?
Half the SD-WAN customers are new customer, especially come from a lot of enterprise. That also enable us to get into the traditional enterprise network security space or even internal. I keep saying the traditional perimeter-based network security now need to be expanded to the WAN side, like SD-WAN 5G and also to internal, like whether the internal segmentation switching or the internal Wi-Fi. That's where we see the probably internal, even bigger market compared to the SD-WAN at the WAN side. We see a huge opportunity, especially we introduced the new NP7. The first product leverage NP7, which is about five times faster than the previous chip, NP6, will help us get inside a network in a more high-speed environment within the cloud. That's also what drive additional growth.
The SD-WAN go to the WAN side and also go to internal network side, help us expand a lot of new market inside enterprise and also gain a lot of new customer for us.
Okay. Very helpful. I have a follow-up for Keith. Keith, you mentioned that ASPs were increasing in your commentary on gross margins. Can you just maybe comment on what's driving that ASP increase? Is that just a mix shift dynamic, or did you actually raise prices on appliances?
Yeah, I think what I'm trying to do is parse out the fact that in the benefit to gross margin, there was really three pieces to it. Indirect, which I would attribute to economies of scale that we're seeing. We have a large warehouse facility that we acquired a number of years ago, I think that's a fairly "permanent benefit" on the indirect side. On the direct side, I think the operations team does a very good job of each quarter working down the average direct unit cost.
The third component was ASP. I kind of broaden that conversation, if you will, or talking point from the last quarter where I attributed to discounting. The reason for that is I would put discounting as a component of ASP, but I also want to give some credit to the ability to the company, if you will, to maintain the somewhat normal price list changes that you have from time to time and not giving those back and discounting.
The other economy of scale working is really the ASIC, right? We are the number 1 unit shipment, probably more than the number 2, number 3, numbers all combined. It really help us really kind of lower the average cost of per ASIC, which give us huge computing power over the generic CPU the competitor using. That's also helping driving the cost lower.
Very helpful. Thank you.
Thank you. Our next question comes from the line of Shaul Eyal with Oppenheimer. Your line is now open.
Thank you. Good afternoon, gentlemen. Congrats on a strong performance. Keith or Ken, Germany and the U.K., or maybe we should call it Frankfurt and then London, tale of two countries, tale of two cities. Talk to us a little bit about what has been driving the strength in Germany, and why do you expect the U.K. to bounce back in the first quarter?
Yeah. Sorry, Ken. I didn't mean to jump on you. In Germany, I think it's just been a balanced growth throughout the quarter. I think we came into the quarter with perhaps some concerns given the economy there in Germany. The diversification that we see within the country, I think paid off for us. I think in the U.K., to answer the question very specifically, when I look at the pipeline in Q1 versus what we saw in Q4, I feel very comfortable with the comment about it returning to positive growth in the quarter.
Fair enough. Maybe along the same lines, that nice bounce in APAC, what's driving that? Do you see that contribution or growth as sustainable within that region?
Yeah, APAC has a pretty good fourth quarter, and also we starting to speed up some hiring there, which is a little bit behind early last year, which also can help drive the future growth.
Well done. Thank you.
Thank you.
Thank you. Our next question comes from the line of Fatima Boolani with UBS. Your line is now open.
Good afternoon. Thank you for taking the questions. Ken, I'll start with you. With regards to SD-WAN, tremendous momentum there. I wanted to understand, from a strategy perspective, how you are pitching the SD-WAN value proposition to your telco and service provider and carrier partners. To some extent, the secure SD-WAN proposition is counter to some of the other areas of telcos businesses like the MPLS stream. I wanted to better understand what your strategy is with telcos. I have a follow-up for Keith, if I may.
Yeah, it's a lower total cost ownership, especially we have a one-box solution compared to some other network vendor, whatever, they need to have a 2, 3 box, one for SD-WAN, one for security, one for networking. We have all this integrated single box. Also because the huge computing power come from our SPU, security process unit, so we can easily outperform and add additional function, combine all the security network function together and still easily 3-30 times faster than other single SD-WAN function box or security box. That's the advantage we have in the technology investment for ASIC chip give us huge computing power, not just for the SD-WAN function, but also additional security function, additional network function if we keeping adding there.
That's where the service provider enterprise see huge benefit, because for them, they can whether use in the box to charge whether service-based revenue or kind of help them lower the enterprise total cost. That's where we see over 70% top-tier service provider opt for our SD-WAN solution. That's where we become a leading vendor. We have the most customer base starting adopt our SD-WAN with 21,000 customer companies starting using our SD-WAN, which combine the SD-WAN security together. Also, it's very interesting. The service we offer with SD-WAN actually is the highest level service we have. We do have a UTM service, we have enterprise service, and then we call a 360 Protection, which including all the UTM enterprise and plus all the provisional service, including SD-WAN provisioning and management service.
SD-WAN definitely helping drive the additional service, additional security into a lot of new enterprise customer, which we count half the SD-WAN deals come from a new customer which never bought our other product before.
Yeah. I think just to follow up on Ken's comment, about the 70% of the SD-WAN service providers. I think what we probably saw, particularly in the first half of 2019, was a little bit of hesitation from the carrier and the service providers and maybe that related to their MPLS revenue stream. We've certainly seen a shift in that thinking, I would say, over the last three or four months.
That's super helpful. Keith, just for you were very specific about the step-up in sales hiring and sort of the higher pace of sales hiring. I'm wondering if you can put a finer point on where these additional sales resources and increased sales capacity is going to be concentrated, whether from a vertical or geographical or even use case perspective. I'd appreciate that color. Thank you.
Yeah. I think the way I'd probably respond to that question is the way we look at it in terms of adding sales capacity, and there's probably two key criteria that Ken and I talk about. One is we want to see somebody who, a sales leader who's demonstrated performance, that when you give them more resources, that they're going to be able to execute with it, and two, that they want that additional responsibility. Luckily, we're in a very good position where that crosses geographic lines, and it crosses verticals. I think that's more the playbook that we're after right now.
Thank you.
Thank you. Our next question comes from the line of Sterling Auty with JPMorgan . Your line is now open.
Yeah, thanks. Hi, guys. Ken, wanted to start out with, as we think about the SD-WAN product roadmap, especially here in 2020, what are some of the key elements that you would expect to introduce this year that have been missing in the solution thus far?
We definitely more working closely with the service provider, which we kind of are more dominant in that space, and offer a lot of managed SD-WAN service. Also a lot of our channel partners have been more working with us, especially system integrator, the big global system integrator. They see the benefit of SD-WAN solution compared to their traditional solution.
The other thing we probably maybe overlook or maybe we're a little bit ahead right now is really the NP7 we talked about in Analyst Day, and then later this month, we'll introduce the first product built with NP7 in our Accelerate in Barcelona, which also will change the landscape. This is more like a product that can go inside the network. That's where the internal segmentation, the hyperscale, some other part of could be even bigger market than the wide area network, which is SD-WAN we were leading the last few years. That's where there's a few driver will keep helping us. Like the SoC4 more helping us more in the SD-WAN in the WAN side, is that integrates system on a chip, and then NP7 will help on the local area network in a high-speed environment.
That's where we're starting to see the traditional perimeter-based network security need to expand into the WAN side and also the LAN side.
Got it. Keith, I apologize. I was bouncing between calls, I apologize if you covered it, I want to better understand the operating margin guidance here for 2020, in particular, how much of that impact is coming from the enSilo acquisition versus the increased hiring, specifically, are you at the end of this maybe increased investment phase, how does that margin outlook for 2020 fit within your longer-term margin guide?
Yeah, I think, very good questions that we tried to cover off in the prepared remarks that a reminder, including the fact that our comment before was that from 2020 through 2022, we expect to average at least 25% operating margin during that three-year period of time. That, first and foremost, that has not changed. The other data point to keep in mind in the commentary was that the M&As, that kind of hit in the tail half of the fourth quarter, the drag in operating margin in the fourth quarter was about a half of a basis point. The drag for the next year, when we have full quarter operations, it's going to be about a one point of drag. One way of looking at it is taking our operating margin at the midpoint and then adding that point back into it.
Got it. Thank you.
Thank you. Our next question comes from the line of Walter Pritchard with Citi. Your line is now open.
Thanks. Question on the subscription side and specifically pretty good performance on the FortiGuard there. Can you help us understand components of that as you've seen that business accelerate this year? What's been the driver of that trend?
Yeah, FortiGuard, go back to some commentary from the Analyst Day. About 85% of FortiGuard are bundles, security bundles. You can add to that some standalone security services, if you will. When you're trying to model it, you can also get a lag effect of when you see high product sales, say higher in 2018, than they were in 2017. Those higher product sales in 2018 are going to attach service contracts, which become revenue in 2019. You're going to get the lift in 2019 from the increase in product sales in 2018.
Got it. Just quick one on acquired revenue. You said a small contribution in Q4. Any contribution from the two acquisitions in the 2020 number?
Yeah, we just rolled it into the total, and I think the comment I gave, was it was far less than 1% in the fourth quarter. I don't really see that changing for the balance of that I have visibility to in 2020.
Okay. Thank you.
Thank you. Our next question comes from the line of Jonathan Ho with William Blair. Your line is now open.
Congratulations on the strong quarter. Just one for me. I just wanted to get your sense of what's happening in the cloud opportunity. You guys mentioned hybrid cloud and sort of the multi-cloud security opportunity. Just want to get a sense for what trends you're seeing, particularly for 2020. Thank you.
Yeah, we do see cloud as a part of our fabric offering. We give the customer flexibility whether they want to deploy on-premise or go to cloud or choosing different cloud provider. We offer the same user interface, the same software, hardware solution for them. We're working with cloud provider, service provider well, and try to expand in that area. That's one of the growth driver for us. We do believe both cloud and edge need to be working together. Certain things good for cloud, certain things good for the edge. That's where of the whole solution instead of only focusing on one solution. That's where Like whether the fabric and the cloud, the edge, and other I mentioned like IoT, OT, and the 5G all have to be working together to make it more secure.
Operator, next question, please.
Thank you. Our next question comes from the line of Michael Turits with Raymond James. Your line is now open.
Hey, guys. Good afternoon, good evening. Great quarter. First for Ken. You announced the Fortinet Secure SD-WAN on Equinix, so SD-WAN, you said as a full service. What are your offerings and what is your strategy on a full cloud-based security offering that you would think of that would be analogous to a Zscaler offering, either for local breakout and/or for zero trust network access?
I think Zscaler don't have SD-WAN, and sometimes we also partner together. On the other side, like a lot of service provider, like Akamai or some other, they do have a quite a broad customer base, enterprise customer, service provider, and leverage their infrastructure. SD-WAN definitely is a new technology solution, can improving the service, lower the cost, and that's where both the service provider, the enterprise customer, all like that solution. That's where we approach from both. One is from end customer angle and with our own marketing force, with our BDR resource, and the other one comes from the service provider partner with them to helping their customer to improving their better service, lower total cost of ownership. That's where we see working with service provider is one of the very important ecosystem for us.
For Keith on cash flow. This year, your cash flow grew less than net income this year in the 20s versus in the 30s. How should we think about it going into next year? Is that just timing that reverses? Should we think about cash flow from ops growing in line with net income or EBIT next year?
If you're looking at the cash flow from operations, then you're excluding the real estate, correct? You're not talking about free cash flow, Michael?
Not talking about free cash flow, just cash flow from ops.
There's nothing different in terms of modeling it other than just maybe when the quarter ended, how payables got paid, and how receivable got collected. Your premise that, basically to put words in your mouth, don't look at any one quarter, but look at it over time, you're right.
Right. In other words, in line with net income or EBIT growth next year is a good guide?
Yep.
Yep.
Great. Thanks very much.
Thank you. Our next question comes from the line of Rob Owens with Piper Sandler. Your line is now open.
Great, thanks for taking my question. I wanted to drill down a little bit into linearity with regard to 2020. I know in 2019, we saw a very strong back half out of you guys, and obviously some of the new products and SD-WAN helped there. You're also making that push up relative to enterprise. Are we seeing the business become a little bit more enterprise backend weighted? Does that play out in 2020? What should our initial linearity thoughts be? Thanks.
Good question. We spent some time with that actually recently looking at it, I think if you start looking at 2018's linearity by quarter, that's probably a pretty good idea of what we think 2019's linearity. We think that's a pretty good idea of what 2020 will look like, at least in terms of how we're modeling it internally. You're probably looking book ending the year with starting off at, say, a 21%, and ending the year in the fourth quarter with maybe 29, 30% kind of a model. In between, we're a model where Q2 and Q3 tend to be very close together. You're probably at around a 24, 25% number for both of those.
Yeah, we also improved the hiring in the second half of 2019, which we hope will be contributing to the 2020 growth. That's where the set of hiring in Q3, Q4 definitely we'll see some sales starting ramp up to contribute in this year 2020.
Great. Then if we look at the large deal metrics, particularly the largest of deals, are these you guys pushing upmarket into data center situations that are massive or more branch network types of situations? Could you unpack that a little bit for me? Thanks.
It's more enterprise. That's because a lot of enterprise see the benefit of whether SD-WAN or we call the infrastructure security involving more product in the fabric. The fabric also helping make the deal larger. That's where with more sales, more partner able to sell multiple product and also the SD-WAN starting to get more like a big enterprise. This definitely help increase the deal size.
Great. Thank you.
Thank you.
Our next question comes from the line of Andrew Nowinski with D.A. Davidson. Your line is now open.
Great. Thank you. Congrats on a great quarter. I also want to ask you a question on your large deal growth. We saw deals greater than 500,000 and those greater than $1 million with impressive growth again this quarter, yet your high-end appliance revenue lagged the small and mid-range appliance growth. I was just wondering, if you could just provide any more color as to why are customers spending more upfront with you since it doesn't look like they're simply just buying larger appliances?
The new products are coming. Like I said, it take us almost four or five years to develop NP7. That's where we finally released, and the first product will come in later this month. That will have a huge advantage compared to some of the old product. That will help.
Andrew, this is Keith. A good follow-up question to Rob and to expand on Ken's comment. I think when you look at where the large deals are coming from, I would probably say there's really three sources for those. One is the SD-WAN that we talked about. Two is the large distributed enterprise that you're referring to. The third is, yes, having success inside the data center and displacing incumbents. I think each of those are contributing to the growth that we're seeing in million-dollar deals.
Great. Thank you. As just a clarification regarding your gross margin, I know you mentioned the economies of scale as contributing to that, but the guidance for 2020 is a significant expansion from 2019. I thought that new appliances typically carry a lower gross margin, at least initially. Given the new appliances you've talked about that are coming out later this month, I was wondering if you could provide any more color as to what might be driving your gross margin higher in 2020 and offsetting that perhaps initial headwinds you normally face with a new appliance.
Yes. Keep in mind, we probably have 70 or 80 different firewalls on the price list of any one model at any one point in time. Also add to that, introducing a new product doesn't necessarily mean it's going to have a significant revenue impact to a given point or to a given quarter. I think I would overplay the new products having an impact on gross margin unless we're doing a lot of them all at once and they're coming online. I think that if you go back to what's actually in the, to the extent you're talking about product gross margin, and I think you were in your commentary, I made reference to three components. One is I think the indirect benefit is here to stay given the economies of scale.
I do believe that the direct benefit, Ken made reference to it with the ASIC advantage, will continue to manifest itself into our pricing and into our billings. Thirdly, I now have two quarters in a row where, whether you want to call it ASP increases or holding line of discounting, I'm not going to commit to say that that's going to be forever. I think those are the components that we're looking at in terms of our modeling of product gross margin going forward. Lastly, if you're looking at total gross margin, it's really a mix shift as well, where at the moment, we're probably modeling a little more services with higher margin than we are with products at this point in time.
Yeah, also with the two new SPU, whether the SoC4, system-on-chip version for all the NP7, we have a huge computing power enhancement on the FortiGate, which also enable us, we're keeping adding a lot of new function, which can also drive the service, helping a less discount and the additional huge value added with the same cost. That also will help improve our margin.
That's great. Thanks for the color.
Thank you. Our next question comes from the line of Dan Ives with Wedbush Securities. Your line is now open.
Yeah, thanks. My question is specifically on the government vertical. Could you just maybe talk about what's going on there? Obviously, there's a lot of transformation going on in deals across, especially on the federal side, where you guys obviously play well. Maybe just talk about that in terms the composition of deals activity and just is anything changing on federal?
Yeah. You must be reading my email. I saw something this morning from one of our salespeople talking about very exciting times are coming in the U.S. Fed. I think really what you're seeing in our model right now is really a diversity in our government business, which includes some benefit from the U.S. Fed, but also state, local, and international governments.
Got it. Ken, could you just hit on 5G? I know you've talked about it before, but just how you're viewing that over the next 12 to 18 months and where Fortinet plays in that opportunity. Thanks.
In which one?
5G.
5G.
Oh, 5G. I think it's still a little bit early. A certain vertical may be ahead of the consumer, but we're working closely with the service provider, but I see it probably still need a couple of years out to see material impact.
Thanks.
Thank you.
Thank you. Our next question comes from the line of Patrick Colville with Arete Research. Your line is now open.
Thank you for taking my question. Congrats on a seriously impressive quarter and next year's outlook. Can I ask a financial question on the free cash flow to start with? How much are you spending in 2020 for the new campus?
Yeah. The real estate spending will probably run between $150 and $160 million all in next year.
Got it. Okay. Very clear. Ken, can I ask you about ransomware? I do a lot of work speaking to CISOs and CIOs, and in my conversations, that's probably the number one threat they're facing right now. I'd love to understand from Fortinet's perspective, how at all that may be driving conversations with you guys and your customers.
That's very important topic, because the majority of attack today now come from inside. That's where internal security, internal segmentation, and at the same time, combined with some other endpoint security, like the company we just acquired, enSilo, some other, and also the story, it's really getting more and more important. Also the new NP7 definitely help driving that direction inside a company network and whether segment different department or server or data source there and even per person. That will help in battle for this ransomware attack.
Great. Thank you very much.
Thank you.
Thank you. Our next question comes from the line of Imtiaz Koujalgi with Guggenheim. Your line is now open.
Hey, guys. Thanks for taking my question. I had a question on the Equinix partnership. Can you just talk a bit about the go-to-market there? Will that be sold by Equinix or will that be sold by Fortinet? How does the rev rec work in that case?
Would it be still a product or will that be recognized as a service offering?
Probably most starting from go to market together, then we're also working on some other more deeper partnership, including certain products or certain service offerings. It's a very good starting of a good partnership.
Yeah. I think it's probably just a little bit early to talk about rev rec, especially since it's in the last 24 hours. We'll touch on that.
Got it. Just a clarification on the guide. Given that your product revenues grew at the same rate in 2018 and 2019, would it be fair to assume that the service revenues, there's no decline in the service revenue growth in 2020? You should basically have the same service revenue growth in 2020 that you had in 2019?
I think we actually included in the guidance service revenue for the year, so I think that'll probably give you pretty good visibility to it in the prepared comments.
Okay, thank you.
Thank you. Our next question comes from the line of Chaim Siegel with Elazar Advisors . Your line is now open.
Hi, guys. Congratulations on a great quarter. I noticed that obviously the billings number was much higher than you thought. I'm just wondering what was the components behind that?
Well, I think we saw very good performance, many geos. I would count the U.S. as being a very strong geo. We also did very well in our emerging markets in the quarter. It was strong. I gave you the revenue numbers, which is a pretty good indicator. I think really if I were to call out in terms of where the strength was in the quarter, I was very pleased with the U.S. and our emerging markets.
Congratulations.
I should, pardon me, I got to mention Latam also, who did a great job again. I'm going to get in trouble. They did a very good job.
Thank you. Our next question comes from the line of Nick Yako with Cowen. Your line is now open.
Great. Thanks for taking my questions. I wanted to ask about Fabric, and just wondering if you can provide any color around the % of FortiGate customers that have deployed a Fabric product, and then maybe how that's trended over the past few years.
If I'm understanding the question correctly, I think there's a very high correlation between Fabric customers and FortiGate products. It's fairly unusual for us to sell a Fabric product to somebody who's not a FortiGate products customer.
Right. Okay. Can you helpful color around the SD-WAN contribution in 2019, and any color on what that contribution was in 2018?
Very small. Low single digits at best, probably.
Okay, great. Thank you.
Thank you. This concludes today's question and answer session. I would now like to turn the call back to Peter Salkowski for closing remarks.
Thank you, Sarah. I'd like to thank everyone for joining the call today and let you know that Fortinet will be attending the following investor conferences in San Francisco during the first quarter. We will be at the Goldman Sachs conference next week on February 11th, and we'll be at the Morgan Stanley conference, also in San Francisco, on March 3rd. Presentations for both of these events will be webcast, and links to these webcasts will be available on the investor relations website for Fortinet. If you have any follow-up questions, please feel free to contact me. Have a great rest of your day. Thank you.
Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect.