Ladies and gentlemen, thank you for standing by, and welcome to the Fortinet 4th Quarter 2019 Earnings Announcement. At this time, all participant lines are in a listen only mode. After the speakers' presentation, there will be a question and answer Please be advised that today's conference is being recorded. 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 Q4 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 Q1 and full year of 2020 before opening the call for questions. During the Q and A session, we ask that you please keep your questions free to limit yourself to one question and one follow-up question to allow others to participate. Before we begin, I'd like to remind everyone that on today's call, we will be making forward looking statements and these forward looking statements are subject to risks and uncertainties, which could cause actual results to differ materially from those projected.
Please refer to our SEC filings, in particular, the risk factors in our most recent Form 10 ks and Form 10 Q for more information. All forward looking statements reflect our opinions only as of the date of this presentation, and we undertake no obligation and specifically disclaim any obligation to update forward looking statements. Also, all references to financial metrics that we make on today's call are non GAAP unless stated otherwise. Our GAAP results and GAAP to GAAP non 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, and thank you to everyone for joining today's call to review our Q4 and full year 2019 results. We are pleased with our very strong Q4 performance. Billions increased 24% to 802,000,000 driven by solid execution and growth across each of our markets, EMEA and APAC. Revenue increased 21% to $614,000,000 with product revenue up 19% and service revenue up 23%. Non GAAP operating margin was 27%.
For 2019, billings increased 21% to RMB 2,600,000,000 dollars Revenue was up 20 percent to 2,200,000,000 and our non GAAP operating margin was 25%. This strong result was driven by our advanced FortiGate technology with SPU and Secure SD WAN, our Immigrates Security Fabric Platform and hybrid multi cloud offerings. Fortinet was recently named 1 of the top 3 vendor in the 2019 Gartner Magic Quadrant for 1H infrastructure. Fortinet's secure 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 our top tier service provider offer our SD WAN solution, we are now the leading SD WAN vendors.
Today, we announced the release of 40 ks40f, the most affordable next generation firewall with secure SD WAN. The FortiApp include our new SoC4 secondurity processor. The FUDAF delivers security computer reaching up 3 to 23 times faster than industry average appliance, which use generic CPUs. The traditional parameter based network security has expanded across our entire infrastructure to the wide area networks, including SD WAN and 5 gs 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 3 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 SBU competitive advantage. Our SBU technology enable us to add cutting edge security and network functionality, including ICRAM, while maintaining strong performance despite network traffic continue to increase. The introduction of the new 4 gs SPU like SoC4 and MP7 as well as the first 40 ks product build with MP7 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 platform that bring together loosely integrate our acquired solution, Fortinet Secure 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 customer to consolidate to a few security vendors. 3rd, our engineer focused culture of continuous innovation strongly positions Fortinet for long term growth and competitive advantage. With at least 3 times the technology pattern compared to our competition, Fortinet's IoT, OT, 5 gs, hybrid cloud and edge solution 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 at our Q4 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 Q4 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 Q4 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 4th quarter review with revenue. Total revenue of $614,000,000 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 239,000,000 dollars 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 4th quarter revenue growth of 19% was consistent with our strong 3rd 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 percent to $376,000,000 and represented 61% of total revenue, increasing 10 points in 4 years. FortiGuard security subscription revenue increased 24% to 205,000,000 dollars FortiCare technical support and other service revenue increased 21% to 170,000,000 Renewal rates remained consistent with prior periods and within the guidelines we provided at the Analyst Day.
Deferred revenue at the beginning of the 4th 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 Q4 results, I'd like to highlight our revenue performance for the year. Total revenue for the full year grew 20% to $2,200,000,000 Product revenue grew 17%, service revenue grew 21% and represented 63% of total revenue. Returning to the 4th quarter with a focus on billings.
Total billings increased 24 percent to $802,000,000 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, and we expect U. K. Billings growth will return to positive territory in the current quarter. Looking at verticals billings by verticals, service providers and MSSPs accounted for 18% of total billings And 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 percent to $2,100,000,000 and short term deferred revenue increased 22 percent to 1,200,000,000 dollars Looking now at deal sizes and illustrating our continued expansion in the enterprise market, deals over $1,000,000 increased 36% to 64 deals. Secure SD WAN was a leading contributor to the increase in the number of deals in excess of $1,000,000 accounting for 10 deals in the quarter, up from 4 deals last year. And 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 Q4, our average contract term increased 1 month to 26 months. As we noted at the Analyst Day, secure SD WAN transactions included greater mix of enterprise customers and somewhat longer contract terms. Moving back to the income statement. In the Q4, gross margin improved 2 30 basis points to 78%. Product gross margin improved 400 basis points to 61.9%.
As we saw in the Q3, 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 4th 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 and 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. And 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. However, the 2 4th quarter acquisitions increased headcount by 135. Excluding these 2 acquisitions, headcount would have increased 19%.
Given the strong operating income performance, net income for the 4th quarter was $132,000,000 or $0.76 per diluted share. Net income for the full year was $432,000,000 an increase of 35%, resulting in earnings per diluted share of $2.47 On a GAAP basis, we reported full year net income of $327,000,000 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 2,009. Moving to the statement of cash flow summarized on Slides 10, 11 12. Adjusted free cash flow for 2019 increased 28% to $776,000,000 Capital expenditures for the Q4 were $47,000,000 including $36,000,000 on real estate spending.
For 2020, capital expenditures are expected to be between $210,000,000 $1,000,000 $35,000,000 again, including spending on the campus expansion. In the 4th quarter, we repurchased approximately 303,000 shares of our common stock for a total cost of $23,000,000 For the full year, we repurchased 1,900,000 shares for a total cost of $141,000,000 At the end of the 4th quarter, the remaining share repurchase authorization was $1,600,000,000 with the plan set to expire at the end of February 2021. Before wrapping up with guidance, I would like to offer information on 2 additional areas: our 4th quarter acquisitions and also SD WAN. First on the M and A side, we completed 2 technology and talent tuck in acquisitions in late October December. With the combined contribution of 4th quarter revenue significantly less than 1%, these acquisitions pulled down 4th quarter operating margin by approximately 1 half of a percentage point.
We expect the impact from these acquisitions on the Q1 and full year 2020 operating margins to be roughly a 100 basis point headwind. 2nd, our secure SD WAN offering continues to be a point of differentiation for Fortinet. In the Q4, secure FD WAN billings represented high single digits of total billings. In 2019, for the full year, Secure SD WAN added about 7 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 Q3 metrics for Secure SD WAN that we provided at the Analyst Day.
Service contracts continue to attach to the FortiGate at a rate consistent with other FortiGate use cases. And finally, new logos continue to account for approximately 50% of secure SD WAN billings. Next, I'd like to review our outlook for the Q1 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 Q1, we expect billings in the range of $635,000,000 to $655,000,000 revenue in the range of $555,000,000 to 565,000,000 dollars non GAAP gross margin of 77.5 percent to 78.5 percent non GAAP operating margin of 19% to 20 percent non GAAP earnings per share of $0.50 to $0.52 which assumes a share count of between 175,000,000 to 177,000,000 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 3 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 3 years and non GAAP operating margin to average at least 25% during this 3 year period. For 2020, we expect billings in the range of $3,025,000,000 to 3,075,000,000 dollars Revenue in the range of $2,525,000,000 to $2,555,000,000 Total service revenue in the range of $1,635,000,000 to 1,655,000,000 dollars non GAAP gross margin of 77.5 percent to 78.5 percent non GAAP operating margin of 23.5 percent to 24.5 percent. While we estimate the recent acquisitions will be a 100 basis point year to year headwind to our 2020 operating margin, included in the numbers above, we believe our operating margin over the next 3 years will average at least 25%. Non GAAP earnings per share of $2.70 to $2.73 which assumes a share count of between $180,000,000 182,000,000 We expect our non GAAP tax rate to be 24%. We expect cash taxes to be approximately $40,000,000 Along with Ken, I'd like to welcome the Cybersponse and again the InSilo 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 and A, please.
Thank
you.
Our first question comes from the line of Brian Essex with Goldman Sachs. Your line is now open.
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, you're kind of at least 50% 15% guide on the Analyst Day. Where does the confidence there come from?
And what are some of the levers that could, I guess, give us some comfort that there's the appropriate level of conservatism in
that number?
Yes. I think the 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. And I think the guidance is certainly within those ranges when you factor in our historical ability to outgrow the market. I think as you get as you pull that in particularly to say the Q1 even the current year, it's much more based upon the pipeline. And 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.
Also, we do increase the sales capacity with additional hiring and sales and marketing, which are close to 20% total headcount increase will definitely help to drive additional growth. Got it. That's helpful.
And 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 a little more challenging to put up positive product revenue growth at the very least. How much did, I guess, 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 you had? And I did hear you comment on high single digit SD WAN contribution, but if maybe you could play in a bigger picture of other contributing factors to those line items in the spending environment overall would be really helpful.
Yes, this is Kai. I think for the network security, we believe we are beginning a lot of market share because the product architecture with our own ASIC, how we call SPU is has huge computing power can keep adding whether security function or the networking function like SD WAN. Even the product we announced today like that's from 3x to 23x more powerful than other competitor industry average. So this will make us keep in gaining market share. And also the ICY market last year is about RMB1.5 billion and may grow 50% year over year in the next few years.
So we are now the leading vendor in SD WAN with most of the customer and most of the service provider also selling to adopt our SD WAN solutions. So we do believe we're also keeping gaining share in that space. So that's also will help us. And the fabric you can see almost double the network security growth because our fabric is mostly internal developed and well integrated. That's more easy to like upsell, cross sell once product add in and because all the other part of fabric kind of working together quite well.
So that's where customers see the benefit of consolidation. So we see that's also a growth trend. There's a few other new technology we also pioneered and but that's probably more long term, maybe still for a few more years to see more materialize, but 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. And 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 application to the cloud actually helping like more deployment in IC WAN. And at the same time, even within the cloud, there is a few research actually, whether from the government and I say all come from like academic, like CMU, the cloud actually increase the security risk. And that's where even within the cloud, you also need to secure the cloud itself. So that's also helping like what we call hyperscale some other kind of approach to get inside the network. And so that's probably beyond the traditional SD WAN side.
So that's where we kind of work with a lot of service provider, cloud provider and make SD WAN part of their total offering. And then we also understand sometimes they have their own business model with more supporting each other instead of more competing on each other. So that's kind of the ecosystem starting working quite well for us.
Thank you. That's very helpful, Ken. And 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. But any color on the jump would be helpful. Thank you.
Yes. I think the math of 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 and the Christmas holiday season is always very busy. I don't think Fortinet is 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 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 placing some competitor solutions that are coming and you're coming in because of the SD WAN capability?
So half the SD WAN customers and new customer, especially come from not enterprise, that's also enable us to get into the traditional enterprise network security space or even internal. I keep saying the traditional parameter based network security now need to be expand to the one side like SD WAN5 gs and also to internal like whether the internal segmentation switching or the internal Wi Fi. So that's where we see the probably internal even bigger market compared to the SD WAN side. So we see a huge opportunity, especially we introduced the new MP7. So the first product leverage MP7, which is about 5 times faster than the previous chip MP6 will help us get inside the network in a very high speed environment within the cloud.
So that's also what drive additional growth. So I do see so the IC 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 getting a lot of new customers for us.
Okay, very helpful. And then 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?
Yes. I think the I think what I'm trying to do is parse out the fact that in the benefit to gross margin, there was really 3 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 that and 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. And then the 3rd component was ASP.
And I kind of broaden that conversation, if you will, a talking point from the last quarter I attributed to discounting. And 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 up those back giving those back and discounting.
The other economies still working is really the ASIC chip, right? So we are the number one unit shipment probably more than the number 2, number 3, number 4 combined, it's really help us, really kind of a lower average cost of per ASIC chip, which give us huge computing power over the generic CPU the competitor using. So that's also helping driving the cost lower.
Very helpful. Thank you.
Thank you. Our next question comes from the line of shawl ayal with Oppenheimer. Your line is now open.
Thank you. Good afternoon, gentlemen. Congrats on a strong performance.
Keith Orkin, Germany and the UK or maybe we should call it Frankfurt and then London, tale of 2 countries, tale of 2 cities. Talk to us a little bit about what has been driving the strength in Germany and why do you expect the UK to bounce back in the Q1?
Yes. I think the sorry, Ken, I didn't mean to jump in
front of you.
I think in Germany, I think it's just been it's been a balanced growth throughout the quarter. I think we came into the quarter with perhaps some concerns given the economy there in Germany, but 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 to comment about it returning to positive growth in the quarter.
Fair enough. Fair enough. And maybe along the same lines, nice balance in APAC, what's driving that? And do you see that contribution or growth as sustainable within that region?
Yes, ePlan has a pretty good Q4 and also we starting to speed up some hiring there, which is a little bit behind early last year, which also can help in 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 and thank you for taking the questions. Ken, I'll start with you. Just with regards to SD WAN, tremendous momentum there. I wanted to understand just from a strategy perspective, how you are pitching the SD WAN value proposition to your telco and service provider and carrier partners, because to some extent, the secure SD WAN proposition is counter to some of the other areas of telcos businesses like the MPLS stream. So I wanted to better understand what your strategy is with telcos?
And then I have a follow-up for Keith, if I may.
Yes. It's lower total cost ownership, especially we have a 1 box solution compared to some other network vendor, whatever they need to have a 2, 3 box, one for SC1, one for security, one for networking. So we have all this integrated single box. And 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 like easily like a 3 to 30 times faster than other like a single SD WAN function box or security box. So 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, we keep an add in there.
So that's where the service provider enterprise see huge benefit because for them they can whether using the box to charge whether service based revenue or kind of help them lower enterprise total cost. So that's where we see over 70% top tier service provider offer our SD WAN solution. So that's where we become a leading vendor. We believe we have the most customer base starting to adopt our SD WAN with 21,000 customer companies starting using our SD WAN which combined SD WAN secondurity together. And also it's very interesting.
So the service we offer with SD WAN actually is the highest level service we have. So we do have like a UTM service, enterprise service and then we call it 360 service, which like including all the UTM enterprise and past all the provisional service including SD WAN provisioning and management service. So that's where so SD WAN definitely helping drive the additional service, additional security into a lot of new enterprise customer, which we count half the SD WAN deal is coming from a new customer, which never bought our other product before.
Yes. And I think just to follow-up on Ken's comment about the 70% of the SD WAN service provider. Yes, I think what we probably saw particularly in the first half of twenty nineteen was a little bit of hesitation from the carrier and service providers and maybe that related to their MPLS revenue stream. But we've certainly seen a shift in that thinking, I would say, over the last 3 or 4 months.
That's super helpful. And Keith, just for you, you're 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.
Yes. 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 2 key criteria that Ken and I talk about. One is we want to see somebody who sales leader who's demonstrated performance that when you give them more resources that they're going to be able to execute whether then 2, that they want that additional responsibility. Now luckily, we're in a very good position where that crosses geographic lines and it crosses verticals. I think that's more of 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.
Yes, thanks. Hi, guys. Ken, I 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're definitely more working closely with the service provider, which we kind of more dominant in that space and offer a lot of managed SD WAN service and also a lot of channel partners working with us, especially system integrator, the big system, global system integrator. So they see the benefit of SD WAN solution compared to their traditional solution. The other thing we probably maybe overall or maybe a little bit ahead right now is really the MP7 we kind of talk about in Analyst Day and then later this month we'll introduce the first product built with ZMP7 in our Accelerate in Barcelona, which also will change the landscape. This is more like a product starting go inside the network. So that's where the internal segmentation, the hyperscale, some other part of it could be even bigger market than the wide area network, which is SD WAN we were leading in the last few years.
So that's where there's a few drivers who are keeping helping us like the Iso C4 more helping us more in the SD WAN in the one side is that integrates system on chip and then MP7 will hop on the local area network in a high speed environment. So that's where we're starting to see the traditional parameter based network security need to expand into the WAN side and also the LAN side. Got it. And then Keith, I apologize,
I was bouncing between calls, but I apologize if you covered it. But I want to better understand the operating margin guidance here for 2020. And in particular, how much of that impact is coming from the InSilo acquisition versus the increased hiring? And specifically, are you at the end of this maybe increased investment phase? And how does that margin outlook for 2020 fit within your longer term margin guide?
Yes. I think very good questions. 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 3 year period of time. And that 1st and foremost, that has not changed. The other data point to keep in mind in the commentary was that the M and As that kind of hit in the tail half of the fourth quarter, the drag in operating margin in the 4th quarter was about a half of a basis point.
And the drag for the next year when we have full quarter of operations, it's going to be about a one point of drag. And so 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? Yes.
FortiGuard, kind of go back to some commentary from the Analyst Day. FortiGuard is about 85 percent of FortiGuard are bundles, security bundles. You can add to that some standalone security services, if you will. You're also going to get a 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.
So you're going to get the lift in 2019 from the increase in product sales in
2018. Got it.
And then just quick one on acquired revenue. How should we think about any contribution from you said small contribution in Q4, any contribution from the 2 acquisitions in the 2020 number? Yes. We just rolled it into the total. And I think the comment I gave was it was far less than 1% in the Q4.
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.
Yes, we do see cloud as a part of our fabric offering. So we gave the customer flexibility whether they want to be put on premise or go to cloud or chosen different cloud provider, which they offer we offer the same like a user interface, the same software, kind of solution for them. And also we're working with cloud provider, service provider well and try to expand in that area. So that's one of the most 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. So that's where of the whole solution instead of only focusing on one solution. So that's where we like whether the fabric and the cloud edge and other I mentioned like IoT, OT and the 5 gs all to be kind of 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. On the first for Ken, you announced the Fortinet Secure SD WAN on Equinix, so SD WAN, you said, as a full service. What's your 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 Zscaler offering either for local breakout and or for 0 trust network access?
I think these scale don't have SD WAN and sometimes we also partner together. And on the other side, like a lot of service provider like Acronyce or some other, they do have quite a broad customer base enterprise customer service provider and leverage their infrastructure. So SD WAN definitely is a new technology solution can like improving the service, lower the cost and that's where both service provider, the enterprise customer all like that solution. So that's where we kind of approach from both. Once from end customer angle and with our own marketing force, with our BTR resource and the other one comes from the service provider partner with them to helping their customer to improving their service total lower total cost of ownership.
So that's where we see working with service providers, one of the very important ecosystem for us.
And then 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?
So if you're looking at 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
for us. Yes. 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. And so 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. So in other words, in line with net income or EBIT growth next
year is
a good guide? Yes. Great. Thanks very much.
Thank you. Our next question comes from the line Rob Owens with Piper Sandler. Your line is now open.
Great and thanks for taking my question. I want to drill down a little bit into linearity with regard to 20 20. And I know in 2019, we saw a very strong back half out of you guys and obviously some of the new products in SD WAN helped there. But you're also making that push up relative to enterprise. So are we seeing the business become a little bit more enterprise back end weighted?
Does that play out in 2020? And what should your initial linearity thoughts be? Thanks.
Good question. We spent some time with that actually recently looking at it. And if you start looking at 20 eighteen's linearity by quarter, that's probably a pretty good idea of what we think 2019's linearity. We've got some pretty good idea of what 2020 will look like, at least in terms of how we're modeling internally. So you're probably looking book ending the year with starting off at say at 21% and ending the year in the Q4 with maybe 29%, 30% kind of a model.
And in between, where our model where Q2 and Q3 tend to be very close together. So you're probably around a 24%, 25% number for both of those.
Yes. We also improved hiring in like second half of twenty nineteen, which we hope will be contributing to the 2020 growth. So that's where the seller hiring in like Q3, Q4 definitely we'll see some sales starting to ramp up to contribute in this year 2020.
Great. And then if we look at the large deal metrics, particularly the largest of deals, are these you guys pushing up market 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 WANO, we call the infrastructure security involved in more product in the fabric. So the fabric also helping make the deal larger. So that's where with more sales, more partner able to sell multiple product and also the SD WAN starting to get more like a design of price. So 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 and congrats on a great quarter. So I also want to ask you a question on your large deal growth. We saw deals greater than $500,000 and those greater than $1,000,000 with impressive growth again this quarter yet. Your high end appliance revenue lagged the small and mid range appliance growth.
So 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 buying simply just buying larger appliances?
The new products are coming. Like I said, it take us almost 4, 5 years to develop the MP7. So that's where we finally released and the first part will come in later this month. So that will have a huge advantage compared to some of those products. So that's where that will help.
Yes. 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 3 sources for those. 1 is the SD WAN that we talked about.
2 is the large distributed enterprise that you're referring to. And then the third is, yes, having success inside the data center and displacing incumbents. And I think each of those are contributing to the growth that we're seeing in $1,000,000 deals.
Great. Thank you. And then 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. And I thought that new appliances typically carry a lower gross margin at least initially. And so 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 the new appliance?
Yes. Keep in mind, we probably have 70 or 80 different firewalls on the price list at any one models at any one point in time. And then also add to that that when you introducing a new product doesn't necessarily mean that's going to have a significant revenue impact to a given point or to a given quarter. So 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 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 3 components.
1 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 ASIC advantage, will continue to manifest itself into our pricing and into our billings. And then thirdly, I now have 2 quarters in a row where whether you want to call it ASP increases or holding line or discounting. I'm not going to commit to say that that's going to be forever. But I think those are the components that we're looking at in terms of our modeling of gross 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.
Yes. Also with the 2 new, SPU, whether the SoC 4, Sys on chip version for all the MP7, we have a huge computing power enhancement on the 40 ks, which also enable us to keep adding a lot of new function, which can also drive the service helping like a less discount and the additional huge value added with the same cost. So 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.
Yes, thanks. So my question is
specifically on the government vertical. I mean, 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. So maybe just talk about that in terms of the composition of deals activity and just is anything changing on federal?
Yes. After reading my e mail, I saw something this morning from one of our sales people talking about very exciting times are coming in the U. S. Fed. But I think really what you're seeing in our model right now is really diversity in our federal business pardon me, in our government business, which includes some benefit from the U.
S. Fed, but also state, local and international governments.
Got it. And Ken, could you just hit on 5 gs? I mean, 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.
Which one? 5 gs. 5 gs. All 5 gs. I think it's still a little bit early.
A certain vertical maybe ahead of the consumer, but we're working closely with a service provider, but I see is 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 and 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 on in 2020 for the new campus?
Yes. The real estate spending will probably run between $150,000,000 $160,000,000 all in next year.
Got it. Okay. Very clear. And then 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. So I'd love to understand from Fortinet's perspective, how at all that may be driving conversations with you guys and your customers?
Yes, that's very important topic because the majority of tech today now come from inside. So that's where internal security, internal segmentation and at the same time combined with some other like endpoint security like the company we just acquired and silo some other and also the store is really selling more and more important. And then also the new MP7 definitely help driving that direction inside company network and whether segment different department or server or data source there and even per person. So that's what helping battle for this ransomware attack.
Great. Thank you very much.
Thank you.
Thank you. Our next question comes from the line of Taz 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? Would that be sold by Equinix or would that be sold by Fortinet? And how does the rev rec how the rev rec work in that case?
Would it be still a product or will that be recognized as
a service
offering? Probably more starting from go to market together and then we're also working on some other more deeper partnership including certain products and certain other service offerings, but it's a very good starting of good partnership.
Yes. And I think it's probably just a little bit early to talk about rev rec.
At least it's in the last 24 hours. So we'll
pass it. Got it.
And then just a clarification on the guide. So given that your product revenues were basically they grew at the same rate in 2018 2019, would it be fair to assume that your 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 will 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 Shane Vigil 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. And I'm just wondering what was the components behind that?
I think we saw very good performance in many, many geos. I would count the U. S. As being a very, 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. But 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.
And I should pardon me, I got to mention Latam also who did a great job again. I'm going to get in trouble and they did a very good job.
Thank you. Our next question comes from the line of Nick Yackel with Cowen. Your line is now open.
Great. Thanks for taking my questions. I wanted to ask about fabric. I'm just wondering if you can provide any color around the percent of FortiGate customers that have deployed a fabric product and then maybe how that's trended over the past few years?
I think there's 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 product customer.
Right. Okay. And Keith, helpful color around the SD WAN contribution in 2019. And any color on what that contribution was in 2018?
Very, very small. I don't 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 Sakhowski for closing remarks.
Thank you, Sarah. I'd like to thank everyone for joining the call today and let you know Fortinet will be attending the following investor conferences in San Francisco during the Q1. We will be at the Goldman Sachs Conference next week on February 11th and will be at the Morgan Stanley Conference also in San Francisco on March 3. 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.