Fortinet's third quarter earnings conference call. At this time, all participants are in the 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 one one. That's star one one on your telephone, and you will then hear an automated message advising you that your hand is raised. Please be advised that today's conference is being recorded. Without further ado, I will now hand the conference over to your first speaker, Peter Salkowski, Vice President of Investor Relations at Fortinet. Peter, please go ahead.
Thank you, Eric. Good afternoon, everyone. This is Pete Salkowski, Vice President, Investor Relations at Fortinet. I am pleased to welcome everyone to our call to discuss Fortinet's fiscal results for the third quarter of 2022. 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 today's call by providing a high-level perspective on our business. He'll then follow with a review of our financial and operating results for the third quarter, providing guidance for the fourth quarter and updating the full year. We'll then open the call for questions. During the Q&A, we ask that you please 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'll 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 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 our GAAP to non-GAAP reconciliations are located in our earnings press release and in the present presentation that accompanies today's remarks, both of which are posted on the investor relations website.
Ken and Keith's prepared remarks today for today's earnings call will be posted on the quarterly earnings section of the investor relations website immediately following today's call. 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 outstanding third quarter 2022 results. Revenue for the quarter grew 33%, significantly outpacing the industry growth rate. We believe that customer recognition of the exceptional value proposition we provided by our high performance FortiASIC technology and integrated FortiOS operating system is driving our ability to take cybersecurity market share. Product revenue growth was very strong at 39%, extending our position as a product revenue leader in the cybersecurity industry. Our product revenue performance reflect the strong demand we have built over the past 18 months across our security solutions, along with the successful execution of our internal team in managing the supply chain challenges.
Three growth drivers, the heightened threat environment, the convergence of security and networking, and the consolidation of security functionality and vendors, together with the opportunity to up-sell additional security services to our significant installed base, are expected to drive future growth. First, the threat landscape, including ransomware, continues to expand and evolve, targeting companies of all sizes, locations, and industries. To counter the threat landscape, we are implementing our unique universal ZTNA across a wide range of customers, driving triple-digit growth for this product and delivering a comprehensive approach to zero trust that is consistent for any user, anywhere on any device, and supporting today's hybrid workforce. Second, for years, Fortinet has led strategy around convergence of networking and security. We estimate the total addressable market for networking and security will increase from $54 billion today to $73 billion in 2026.
Convergence accelerates digital transformation and substantially reduces our protection costs by combining networking modernization with dynamic security that seamlessly spans every part of a network, especially now that many companies are merging SOC and NOC operations together. Fortinet is leading the convergence trend with a wide range of technologies, including network firewall segmentation, secure SD-WAN, OT security, and 5G in a single operating system, which can be deployed as hardware, software, cloud, and as a service. Fortinet continues to gain secure SD-WAN market share as our integrated secure SD-WAN solution delivers better security, performance, and efficiency over more traditional offerings. In the quarter, SD-WAN and OT bookings grew over 45% and 75% respectively, and together accounted for over 25% of total bookings. We believe we can achieve number one market share in SD-WAN in the next couple of years.
Today, we announced the FortiGate 1000F, our latest innovation in convergent networking and security. Powered by our new NP7 SPU, the 1000F delivers five to 10 times higher performance across six major network security functions by consuming 80% less power versus competitive solutions. The lower power consumption was a contribution factor in our top 2% ranking in S&P Global Corporate Sustainability Assessment. Our third growth driver is the consolidation of our vendors and the product functionality. With FortiASIC's huge computing power advantage, FortiOS can integrate more security functions than our competitors. Together with over 30 key products ranging from endpoint to network to the cloud security, Fortinet provides our customer with easier operation while lowering the management cost and the total cost of ownership. Additionally, we are well focused on upselling value-added security services to a significant customer base.
According to IDC second quarter unit share data, Fortinet holds a number one market share position for units shipped at 43%, up 210 basis points. We expect to reach 50% market share in the next few years. This leadership position and the substantial installed base creates attractive economies of scale and an opportunity to upsell additional security services. Before turning the call over to Keith, I would like to thank our employees, customers, partners, and suppliers worldwide for their continuous support and hard work. Keith.
All right. Thank you, Ken, and good afternoon, everyone. Let's start with an overview of our strong third quarter performance. Revenue of $1.15 billion was another quarterly record for Fortinet, increasing 33% year-over-year and 12% sequentially, our highest third quarter sequential growth rate in 11 years. We continue to deliver better than industry average top line growth and generate strong profitability. Our operating margin exceeded guidance at over 28%, driving the adjusted free cash flow margin to 40%. Our history as a public company has revolved around the rule of forty, measured as the combined total of revenue growth and operating margin. Impressively, the Q3 total came in at over 60. We continue to see success in our strategy for expanding further into the large enterprise segment.
The number of deals over $1 million increased over 80% to 153 deals. The total billings value of deals over $1 million more than doubled, driven by a record number of deals over $5 million. In Q2 2020, bookings increased over 40%. Our strong third quarter results reflect solid customer demand across both our core and enhanced platform technologies and the exceptional performance of the team in a challenging supply chain environment. We believe the investments we've made in building our platform and our go-to-market engine enables our customers' digital transformation journeys. Our platform strategy allows customers to converge networking functionality with security capabilities while consolidating cybersecurity products, providing security across their entire digital infrastructure while lowering their operating costs.
Recently, the Forrester Wave Enterprise Firewalls report acknowledged the success of our investment strategy, placing Fortinet as a leader for the first time in its history. According to Forrester, and quote, "Fortinet excels at performance for value and offers a wide array of adjacent services. Long known for its bang for the buck approach to network security, Fortinet has built a flexible and capable platform with its flagship product, the FortiGate Firewall." Taking a closer look at the income statement, product revenue grew 39%. Product revenue growth for our core and enhanced technology platform products increased 29% and 51% respectively. The product revenue growth rate accelerated over four points sequentially, especially impressive, given it is our toughest year-over-year comparison in over 10 years.
Service revenue was up 28%, accelerating three points sequentially, driven by strong product revenue growth and seven consecutive quarters of increasing short-term deferred revenue growth rates. Support and related service revenue was up 28%, accelerating over two points sequentially to $311 million, while security subscription service revenue was up 29%, accelerating four points sequentially to $370 million. Total revenue in the Americas increased 34%. EMEA revenue increased 37%, and APAC posted revenue growth of 23%. Total gross margin at 76.2% exceeded the high end of our guidance range. Product gross margin at 61% was up 30 basis points year-over-year. Services gross margin of 86.6% was flat year-over-year, but up 70 basis points sequentially.
Operating margin of 28.3% was up 250 basis points, benefiting from FX and the operating margin leverage that comes with higher revenues. Shifting to billings. Billings of $1.4 billion were up 33%, representing the sixth consecutive quarter of billings growth in excess of 30%. Core platform billings were up 27% and accounted for 67% of total billings. As shown on slide six, entry-level FortiGates posted very strong billings growth with the mix shifting 16 points in their favor, driven by demand, and as we expected, improved supply. Enhanced platform technology billings were up 45% and accounted for 33% of total billings, a positive mix shift of three points. Average contract term was flat year-over-year at 29 months. Looking at the statement of cash flows summarized on slides seven and eight.
Free cash flow was $395 million. Adjusted free cash flow, which excludes real estate investments, was $464 million, representing a 40% adjusted free cash flow margin. DSO was down five days sequentially, while increasing 12 days year-over-year to 75 days. Cash taxes were $69 million. Capital expenditures were $88 million, including $69 million for real estate investments. We repurchased 10.2 million shares of our common stock, with a cost of $500 million, bringing the year-to-date totals to 36 million shares at a total cost of $2 billion. The remaining repurchase authorization totals $530 million. Regarding backlog, the backlog at the end of the third quarter was up slightly from the end of the prior quarter, with FortiGate firewalls accounting for just one-third of total backlog.
We expect fourth quarter ending backlog to be relatively consistent with the third quarter backlog, as we are seeing early signs of a transition back to more normalized customer buying behaviors. Moving to guidance. The current environment favors a Fortinet style platform that offers integrated solutions and strong security capabilities at an attractive cost of ownership. To enhance our ability to capture our share of the larger market opportunity, we plan to continue to invest in innovation across our integrated platform offerings. Now I'd like to review our outlook for the fourth quarter, summarized on slide nine, which is subject to disclaimers regarding forward-looking information that Peter provided at the beginning of the call.
To start, as part of the Q4 guidance setting process, we considered several factors, including the greater macro uncertainty today, and with it the increased risk of forecasting the timing of certain larger transactions. The transition to more normalized customer buying behaviors, which means there is less of an emphasis on ordering to get a place in line. For comparison, in the fourth quarter of 2021, when supply was tighter, backlog increased over $120 million and contributed to 49% bookings growth. Lastly, elevated year-over-year top line comparisons that include certain one-time items, adding a couple of points to service revenue growth and fully cycling the Alaxala acquisition. In response, we have slightly widened our top line guidance ranges. For the fourth quarter, we expect to again reach the rule of sixty.
With that, the key messages include billings in the range of $1.665 billion-$1.72 billion, which at the midpoint represents growth of 30%. Revenue in the range of $1.275 billion-$1.315 billion, which represents growth of 34%. Non-GAAP gross margin of 75%-76%. Non-GAAP operating margin of 30%-31%. Non-GAAP earnings per share of $0.38-$0.40, which assumes a share count of between 795 million and 805 million. We expect capital expenditures of $75 million-$85 million. We expect a non-GAAP tax rate of 17%. For the full year, we expect billings and revenue growth to exceed 30% for the second consecutive year.
Billings in the range of $5.54 billion-$5.595 billion, which at the midpoint represents 33%. Revenue in the range of $4.41 billion-$4.45 billion, which represents growth of 33%. Perhaps for context, we should note at the midpoint, these full year billings and revenue growth rates are three points higher than the initial growth rates we provided in early February, despite the start of the war in Ukraine in later February, significant increases in interest rates and increasing uncertainty in the macro environment. Importantly, full year backlog is expected to be above the February estimate of $350 million.
Total service revenue in the range of $2.645 billion-$2.655 billion, which represents growth of 27% and implies full year product revenue growth of 42%. Non-GAAP gross margin of 75%-76%. Non-GAAP operating margin of 26%-27%. At the midpoint, a year-over-year increase of thirty basis points. Again for context, at the midpoint, gross and operating margin expectations are fifty and one hundred basis points above the February guide, respectively. Non-GAAP earnings per share of $1.13-$1.15, which assumes a share count of between 800 and 810 million. We expect full year capital expenditures of $325 million-$335 million. We expect our non-GAAP tax rate to be 17%.
We expect cash taxes to be $265 million. Before wrapping up, I'd like to offer some preliminary thoughts on 2023 and our midterm targets on the heels of a very strong set of growth in 2021 and 2022. We continue to successfully balance growth and profitability while investing in longer term innovation and go-to-market initiatives to fuel future growth. The strength of our business model includes its diversification, margins that provide capacity for future investment, and a rich mix of higher margin recurring service revenues. As we saw in the height of the pandemic, the diversification helps mitigate the risk of economic slowdowns. Specifically, in 2020, we delivered operating margins of nearly 27%, adjusted free cash flow margin of over 38%, and top line growth of 20%.
During the past 12 months, we have rarely exceeded our operating margin targets, while increasing our engineering headcount by about 20% and significantly increasing our future sales capacity by over 25%. Including a greater than 50% increase in new non-tenured salespeople. While we will provide more detailed 2023 guidance when we report our fourth quarter results, it's worth noting that service revenue accounts for 60% of total revenue, with gross margins hovering above 85%. We see continued service revenue growth driven by two years of very strong product revenue growth and seven consecutive quarters of accelerating short-term deferred revenue growth.
With a strong business model and a history of being able to execute, we are confident that our momentum will continue and point to our key growth drivers, including strategic investments, the heightened threat environment, the convergence of networking and security, and cybersecurity consolidation. Cybersecurity, though not immune to economic slowdowns, is expected to remain a relatively safe harbor. We remain on track to achieve all of our medium-term financial targets from our May 2022 Analyst Day, including $10 billion in billings and $8 billion in revenue in 2025, each representing a 22% three-year CAGR from the midpoints of our 2022 guidance.
The targets also include an average non-GAAP operating margin of at least 25% for the four years from 2022- 2025, and a 2025 adjusted free cash flow margin in the mid- to high-30% range. Illustrating our long-term focus for balancing growth and profitabilities, our targets remain committed to the rule of 40 or better. I'll now hand the call back over to Peter to begin the Q&A.
Thank you, Keith. As a reminder, during the Q&A session, we ask that you please limit yourself to one question and one follow-up question to allow others to participate. Eric, we are ready for the Q&A.
Excellent. Also, as another reminder, if you want to ask a question, press star one one on your telephone and wait for your name to be announced. Okay, please stand by while we compile the Q&A roster. Our first question comes from Fatima Boolani at Citi. Fatima, your line is open.
Thank you. Good afternoon. I appreciate you taking my questions. Keith, this one's for you just with respect to the Q4 guidance and the outlook. Appreciate you kind of breaking down the three principal factors that went into that. But I wanted to dig in specifically on the comment you made about normalized buying behavior as it relates to the backlog build. I think what I inferred from your comments is that while the backlog is going to be sequentially up and sort of higher than what you initially pointed out to be maybe $350 million of ending backlog, you know, that's certainly below the $500 million that you were previously telegraphing.
I just wanted to better understand sort of the modulation downward on the backlog there and how the sort of normalized buying behavior contributes to that. I'll ask my follow-up.
Okay. I think when we talk about normalized buying behavior, you know, I think that we certainly saw some enterprise customers in the U.S. during the supply chain challenges that were placing orders, you know, to get in line, to hold their place in line for when inventory was available. I think, you know, say a year ago or so, that was an appropriate behavior when there was a lot of uncertainty around the supply chain, and maybe they were planning for what they were gonna do in 2022. I think that somewhat in general now, and maybe Ken will talk more about this, you know, it's, I think people are getting the sense that the, certainly we are, that the supply chain is a little bit easier to forecast and somewhat easier to manage.
I don't mean by any stretch easy, but I do think it's easier. With that, I think you're starting to see the market drift back towards, and I emphasize start, to what I would call more traditional buying, which is, you know, when they need it, they're placing the order.
Yeah. Also look at the composition of our backlog. It's only one-third or less related to our network security platform, FortiGate. More than half relate to like a switch and FortiAP, which is a networking equipment, which is a kind of a, it's a industry problem in the networking side, because the networking device tend to be more changeable, more standard driven. A lot of customers sometimes double, triple order, try to get ahead of whatever the supply chain issue and also some of them can easily cancel once they got a product.
That's why we feel probably keeping track in the backlog may not be the best way to forecast the business, and we should be more focused on security related, especially driving the future service based on huge FortiGate installation base.
Thank you. Keith, just a clarification on the services revenue trajectory and more broadly thinking about next year. We saw the re-acceleration this quarter in services revenue. Wondering if you can give us a quick update on how the delayed registrations from earlier in the year and transactions from earlier in the year are trending and how we should think about that filtering and flowing into our models for next year. Thank you.
Yeah. I think we've been messaging throughout the quarter, various conferences that and even in the prior quarter, that we had a clear expectation that service revenue growth has accelerated, so we're very pleased to see that. I think there's a number of things that are providing a tailwind into that. Customer registering units is part of that. I think also the price increases, you know, making its way, first into orders and deferred revenue and now into the income statement. You know, keeping in mind that we have contracts that sometimes are as long as five years, that will give you a sense of how long the tailwind may relate to price increases as we will continue to cycle through renewals at old prices and replace them with new contracts.
I think we feel good about the direction of the service revenue and the margins that it provides, together with the fact that it's 60% of our business.
Okay, thank you. Our next question comes from Saket Kalia at Barclays. Saket, your line is open. Please go ahead.
Okay, great. Thanks very much for taking my question here. Keith, maybe just to start with you. I'd love to just zero in on product revenue growth a little bit for this year. Can you just maybe talk about some of the growth drivers for product revenue this year that aren't expected to repeat next year? Again, very helpful detail kind of thinking about total billings for, you know, for kind of following years. But for product, what are some of the one-off things that we should be keeping in mind, like an Alaxala, like, you know, price adjustments, just to sort of think about what normalized growth in product might look like as we start to think about following, you know, the following years.
Yeah, I think Alaxala is probably the easiest one to talk about in terms of providing numbers. We have talked about the fact that their revenue stream was probably something on the order of $130 million-$140 million when we acquired them, and reminded people that they are a March 31 year-end, so their fourth quarter is a little bit off cycle. You know, I think that its growth is single digits, so I think that probably gives people a good level expectation. Reminder there that our interest in Alaxala is a lot around the IP and some opportunities that we have there to do things more longer term, if you will.
In terms of other unique things about product revenue in the quarter, I mean, I think that, you know, as the backlog comes into revenue, it, you know, as we go through the end of 2022 here and certainly into 2023, you know, it's gonna provide, again, a fairly significant tailwind to what the product revenue growth will be in 2023, assuming we get the drawdown and backlog that we may see.
Yeah. Also, we believe the growth driver, especially the converged network and security, we don't think in that slowdown will be keeping driving the product revenue growth in the next five to 10 years. You can see the secure SD-WAN and OT both has pretty healthy growth. At the same time, what will continue the growth in the next five to 10 years in a huge market potential.
Got it. Maybe for my follow-up, really for both of y'all, make a jump ball here. You know, I think in Q3, we had operating margins of about 28%. I think the guide for Q4 is for margins a little bit higher. You know, when I think that long-term guide out to 2025 of at least 25%, it feels like you're doing a lot better than that here in the near term. Maybe the question is, how do you sort of think about that balance, right, in terms of growth, maybe moderating or normalizing, as we mentioned, versus sort of that long-term margin?
I think that's where if you look in the 13-year history, we as a public company, we always balance the growth and with the margin. That's where we feel the 25% above is a healthy margin. Then we can also give the money to invest in the growth, become a leader in the space. That's where we're continuing to balance. If the growth slow down, definitely will be more helping in the margin. That's why we keep on saying the rule of 40, probably in the last few quarters, we kinda even reached the rule of 60 now. That's where also when the growth slow down, and sometimes the service revenue has a higher margin, which can also help in the margin.
We do expect the growth will continue in the next few years with the three growth driver I mentioned and the plus additional service revenue to our big installation base. A lot of them not quite enabled the security service revenue yet.
Yeah, I would probably sort of agree with Ken and offer just a little more detail on it. You know, keeping in mind that, you know, we sell in U.S. dollars, so there's really not a direct FX impact there on the revenue line. Obviously, you can get into certain countries where the pressure on discounting, if you will, because our exchange rates can be a little more intense. But on the OpEx, you know, because 30% of our business is the U.S. and the rest is international, you know, we do get a tailwind from OpEx from the strength of the U.S. dollar. I think you're seeing that in Q3, and you're seeing that in Q4.
Probably why it's important is that, you know, we've talked for a number of years now around and made reference to 25% operating margin. If you go back four years ago, five years ago, it was probably a target to get to 25% operating margin. Since then, we've talked about, you know, averaging 25%, setting a floor at 25%. It has certainly served us well as a way to help other people understand about how we invest in the business. As Ken makes reference to it, you know, as we have, you know, funds available over that 25% operating margin, it creates opportunities for some, not necessarily all, as you're seeing currently, of those margin dollars to be reinvested back in innovation and back into our go-to-market strategies.
Got it. Very helpful. Thanks.
Okay, we're just lining up the next question. The next question comes from Hamza Fodderwala at Morgan Stanley. Hamza, your line is open. Please go ahead.
Hi, good evening, gents. Thank you for taking my question. Keith, on the backlog, you know, look, sometimes, you know, you have too many metrics that creates too many noise and, on the supply chain front, it seems like it's getting a bit clearer. Could you give us any more granularity on how that backlog and that booking trajectory looked relative to your guidance, which I think when you got into it, you were saying about 36% growth at the midpoint for bookings. Just curious how that shook out in Q3.
Yeah, I think, you know, I'll come back to kind of Ken's commentary around backlog, which is really what kind of drives the conversation about bookings. You know, I think a year ago when we introduced the backlog metric, there was a lot of uncertainty around what the supply chain crisis was gonna look like and how it might impact our business. The purpose of providing the backlog disclosure and the booking disclosure then was to kind of round out, you know, and help investors understand more about our business model as we go forward.
As we heard in the question earlier, from one of the questions, you know, at the beginning of the year, you know, we kind of swagged backlog growth at $350 million in the first quarter, and then came back and said, in the second quarter, maybe, you know, it's gonna get closer to $500 million for the full year. Now I think we're looking at a number that's, you know, gonna be less than that. You know, something in the fours probably seems reasonable from where we're at. I think when that net, the message. There's two messages. One is, you know, I think we're becoming much more comfortable with our ability to execute in this environment and maybe some easing in the environment itself.
Then secondly, I think that, you know, it was always our intention, and I think we messaged this, that these would be short-term metrics that we would provide. I think they've served us and our investors well for an extended period of time, but it's probably time now that we feel that we've gotten a better control on it to bring us back in line, if you will, with what our industry competitors are disclosing and not disclosing.
Makes total sense. Just to follow up really quickly, I mean, is it fair to say that your bookings growth is still higher than your billings growth? Obviously, your backlog grew, so you're still expecting underlying bookings to be higher than 30% this year.
Yeah. We're not going down to the detail of talking specifically about bookings, as I just mentioned, going forward, nor backlog more than what we've given to this point.
Okay. Thank you.
Okay.
Okay. Our next question comes from Rob Owens at Piper Sandler. Rob, your line is open. Please go ahead.
Gregg, good evening. Thanks for taking the question. Just one from me. Curious with the supply chain getting a little bit easier, how you're thinking about gross margin, both kind of in the short term as well as the medium term. Thanks.
I think the component and also the cost continuing to go up. That's where. We still have a pretty tight inventory to make most shipments shipping by air instead of by ocean. That's where. We're keeping our just all the cost and probably some of them we eat ourselves, some of them we may do some price increase. We also feel even some price increase, we continue to have a price advantage compared to competitive industry average with our products. That's where the margin we feel probably will be most stabilized. Yeah, that's probably the overall supply probably keeping improving.
Yeah. Again, spot on with that. I'd probably a little more granularity. You know, I think if you maybe look at it between product gross margin and services gross margin, the product one is the one that's probably more volatile related to what we're seeing. We've certainly heard commentary that maybe things are easing a little bit with the chip manufacturers, but I will say that there's no indication of any sort of cost reductions or savings that are coming from either chip manufacturers or the component suppliers. We'll see how that plays out.
You know, our strategy has been, and Ken alluded to this, is that we came into this economic cycle a year ago believing that we had a price and performance advantage and that we could raise prices and our target was really to pass along most, but not all the price increases, call it ±1% margin. It's kind of our target every quarter. It doesn't fall that way every quarter because of various variables. I would imagine that to the extent that prices can remain to be elevated as we move into 2023, you know, that's kind of the starting point for our pricing strategy into 2023 as well, again, because we have not seen signs that we've lost the price for performance advantage. In fact, we continue to win that way.
Service is a little bit different. I mean, the largest cost component in services is labor. If you look back, you know, we're a company that has its annual merit increases in the first or second month of the year. You kinda get a rather immediate jolt on the COGS line from those compensation increases, which is certainly appropriate. Then you have to grow the service revenue into it. I think that's part of the conversation about why you saw the reference to sequential margin increases. On the revenue side, you know, it gets fairly complex.
Well, maybe not complex, but you know, thinking through how price increases that you know, started about a year ago and kind of hit a quarterly pace, if you will, how those price increases will make their way first onto the balance sheet in deferred revenue, and to what extent each item is going to reflect all those price increases, and then how it will come off the balance sheet in future periods. You will get tailwind from the price increases, and I would expect that particular tailwind to continue for an extended period of time.
Ken and Keith, thank you.
Mm-hmm.
Okay. Our next question, just, connecting the line now, comes from Shaul Eyal at Cowen. Shaul, your line is open. Please go ahead.
Thank you so much. Good afternoon, guys. Keith, question on APAC. Fastest performance in, I think, like two years. What was driving that? I have a follow-up.
Yeah, I think we've made a leadership change there around the end of June, beginning of July. We had a retirement. I think that's you know just kind of the transition of leaders, if you will, as one was exiting into retirement, and we brought somebody on. I think we feel very very good about in terms of their abilities. I think the other part of it is, you know, that you're starting to see the lapping effect of Alaxala, because all of Alaxala is sitting in APAC. You're gonna see that now as we roll up on basically the full quarter comparisons that impact.
Understood. On Fortinet sales, maybe looking at it from a tier perspective, it was slightly more mixed than prior quarters, entry-level actually representing most growth versus the mid-range and high-end. Any color on that front?
That's where we see pretty strong growth related with SD-WAN and OT, which more using the low-end units. At the same time, the supply chain improvements help a little bit. That's where we'll be able to ship more product in the low-end side. We still have some backlog in the middle high end, but the low end has some improvement by redesign some of the product and also better supply chains right now.
Ken's talked about this in the past, you know, the ability to introduce the new FortiGate 70F product in the second quarter. We were a little bit hamstrung in Q2 and the beginning of Q3, even back into Q1, really, on the low end. I think we kind of messaged a bit in our conversations over the last quarter or so that, you know, we expected low-end supply availability to really jump, if you will, in the third quarter. We did see that. It's really more of a supply conversation, in some ways, as much as it is a demand conversation.
Thank you for the color. Appreciate it.
Okay, we're just bringing our next caller live. Okay, next caller is Shrenik Kothari at Robert W. Baird. Shrenik, your line is live. Thank you. Hello, Shrenik? Okay, let's go to the next question. Standby. Brad Zelnick from Deutsche Bank. Brad, your line is live.
Thank you so much, and thank you for taking the questions. Ken, just a big picture question for you to start out with. You mentioned Fortinet's success is in part coming from the industry trend of vendor and product consolidation. Why is Fortinet so well positioned as a platform for consolidation, and how does this inform your product and corporate development roadmap in terms of the need for even more product breadth to compete with other platform competitors out there that keep adding additional functionality?
I think we have a few unique advantage. The first from day one, we developed the FortiASICs, which have a huge computing power increase compared to using traditional CPU. Also, our FortiASIC also working side by side with the CPU. That's the huge computing power advantage come from the FortiASIC give us a more computing power for the FortiOS to run more function, more security function, including a lot of networking function. That advantage is none of our competitor have that. That's making us keeping driving the market share and also the unit shipment I mentioned. Now we like a 43% of our market share on the unit shipment there.
That will be keeping give us a long-term growth going forward. Because also on the convergence of security and networking, the secure computing power is a must-have. It's a huge need to address both security and networking function there. Second is the FortiOS is well integrated together with more function, leverage the computing power. That's also kind of huge advantage for us compared to some other competitor, whether they have to use, like, different blade with different function, or they have to offload to some like a different box or even to the cloud to address some of the secure computing power there.
Third one, we also have about 30 different products, mostly home developed and integrate, automate well together. So that's also what helping drive, we call the our Security Fabric, gonna call the mesh network. So that's also helping the customer to lower the management cost and total cost of ownership. I think all these 3 factor will keeping driving Fortinet better position for the consolidation, both on the product functionality and also on different product into a single vendor platform strategy.
Ken, thank you for that, it's clearly working very well, your strategy. Maybe, Keith, just for you've disclosed quite a bit of information, so much so that I have a very simple question that I just might have missed. Can you just very clearly explain further reduction in the full year?
billings guidance for that you've given us now the update on with these results. Thanks.
Yeah, I think you're talking about full year, fourth quarter, one and the same at this point, and I would really just point to the macro environment and what we've seen really over the last 90 days in terms of economic activity, if you will. I think when you look at how that manifests for us, you know, somewhat specifically, yeah, I think I'm getting a little more cautious in some of the forecasting of close timing on some of the very large deals. We've been very successful over the last few years, and you saw some of the numbers about enterprise penetration with our growth in the enterprise. The deals have actually gotten significantly larger as we've gone forward.
I think it's appropriate in that environment to be a little more cautious on what we expect the close rates to be. The business itself is very healthy. If I look at the end of the spectrum, the small enterprise part of the business, for example, it actually outgrew the other two parts of the business in the last quarter by it took about a point of mix, I think, from the other two. I feel good about the business, but just a little cautious about the macro environment as we go forward and how to forecast what's coming from the sales team.
It makes total sense and in line with a lot of other data points that we're all seeing out there. I guess just maybe, you know, as you think about what contributes to that. It doesn't sound like it's anything competitive, but you know, what are the customers doing? Are they shrinking deal sizes? Are they just taking more time and sweating out their existing assets? You know, any other color on that would be helpful. Thanks.
Yeah, I don't think we're gonna see deal sizes getting smaller, you know, for one, because we're moving into the enterprise. You know, if we were more established there, and it was just kind of the same routine over and over, the fact that we're growing in the enterprise, and again, you saw the numbers, is going to by itself increase our average deal size. I certainly do feel that, you know, there's caution, you know, as corporate America and the rest of the world is probably going through their budgeting cycles right now and looking at what they're planning for not only the end of 2022 and 2023.
You know, I think the other aspect of that, and again, I think this is fairly consistent with other comments we've probably heard, yeah, I don't think it's a good time to really get in a position of forecasting some sort of significant budget flush in the fourth quarter. If it develops, that would be fantastic. Yeah, I think prudence is a little bit appropriate here.
Makes total sense to me. Thank you so much for taking the questions.
Thank you.
Oh, thank you, sir. Next up, we have Shrenik Kothari. Shrenik, from Robert W. Baird, your line is open. Thank you. Shrenik Kothari at Robert W. Baird, your line is open. Okay, we will move on to the next question. Please stand by. Tal Liani, at Bank of America. Tal, your line is open.
Hi, this is Madeline for Tal Liani today. Just two quick ones for me. I apologize if this has already been mentioned since we're covering a few earnings right now. You know, just to be very pointed about it, you know, last quarter we heard bookings was a little bit softer than expected. This quarter, no disclosure on bookings. Again, I apologize if this was already mentioned, but just wanna get, you know, Keith, from your perspective directly, why no bookings for this quarter after a weaker quarter of bookings last quarter?
Yeah, we've talked at length of this before you jumped on the call. For everybody's benefit, I'll just quickly kind of go through it. Yeah, I think when we got into this conversation a year ago, we felt the backlog, which is really the driver of the bookings conversation, was something that was, you know, we thought was important for investors to understand, you know, to be able to track how we're performing as a business and what they're seeing in the drivers. As we've moved forward, you know, I think that if you fast-forward a year later, I think we feel more comfortable now about some of the backlog forecasting. Earlier, we made reference to, you know, backlog may exit the year something closer to 400 or a little bit north of that.
With that in mind, you know, I think we're bringing ourselves back into what I would call industry norms, where nobody else really discloses this information, but we thought it was appropriate for the first year. I would also offer one comment about backlog that's important, and we get a lot of conversations around cancellation rates. Our cancellation rate has been extremely consistent at about 4% each and every quarter.
Yeah, also the composition of backlog is kind of different now compared to one year ago, which is one year ago, I have to say majority probably more related to the FortiGate. Now FortiGate is less than one-third of the whole backlog. The majority of backlog actually comes from a FortiSwitch and FortiAP Wi-Fi, which is also kind of a more industry problem, which the FortiSwitch and FortiAP more easily customer can change in different vendor compared to the security product they have to design in. They have to it's a lot of high switching cost. So that's why we feel the backlog sometimes unpredictable and with the majority all come from FortiSwitch and FortiAP.
Got it. Thanks so much. Just one follow-up question there too. You know, I know Greg just mentioned having a little bit of prudence for, you know, going into next year and just your guidance. I'm also just wondering on the visibility side, are you seeing less visibility, the same visibility? Can you just talk to the trends that you're seeing there in your own pipeline?
I think the pipeline visibility is very good and the pipeline growth is very strong. You know, and I think that, you know, one of the things that we did at the end of the prepared remarks was we went back to the midterm guidance numbers that we gave, being a $10 billion booking company in 2025 and $8 billion in revenue and margins of 25% or more, and basically reiterated that. I think we're doing that, which requires a 22% CAGR from this point forward. We're doing that, you know, after looking at our pipeline, looking at the strength of our pipeline so that it makes sense to us.
Got it. Thanks so much.
Okay, getting ready for our next caller. Our next caller is Keith Bachman at BMO. Keith, your line is open. Please go ahead.
Many thanks. I also had to, Keith, to start with you, I wanted to go back to the billings commentary for Q4. Just so I understand the revenue base is essentially the same, and therefore, it's a DR impact that you're guiding lower. As you mentioned that you're expecting backlog to be less than $500 million and maybe, you know, 400 or 400 and change, is some of that backlog actually then flowing into the billings and therefore, you know, the billings guide down is even a little bit worse, Keith, than it actually appears? Any other context you could draw out on where specifically that billings weakness is. Is it Europe or what have you? If you could flesh those out, then I had a follow-up for Ken, please.
Yeah. I wanna be clear. We are expecting backlog to actually increase from Q3 to Q4. Not significantly, but slightly.
Okay. Therefore, none of that backlog then is flowing into that billings is anticipated, right?
Correct. I mean, you're always gonna get some existing backlog that flows in the billings, but you're gonna get new backlog. Net-net, it's gonna be an add in total to it for the year. I think it's a good question about Europe. I don't wanna gloss over that. Europe performed, you saw the revenue numbers. While we don't disclose it, I would say the billings numbers, Europe performed very, very well in the quarter. Their pipeline remains extremely strong as we go forward. Now, we'll see as we get through and get closer to 2023. I sort of would readily agree that there are certain tailwinds that are appropriate for Europe. But to this point, they've done very, very well.
Okay. Ken, for you then, it relates to that, very directly relates. As we think about Europe in calendar year 2023, the currency, as you alluded to, is a headwind. I was just in Europe, and customers view that the prices, since you price in dollars, have actually gone up quite a bit. Is there a risk or how should we think about, is there a risk of prices actually needing to come down because of the dollar-based pricing and therefore the, you know, significant price increase, if you will, felt by the Europeans? Is there a risk that prices need to come specifically down for currency next year?
Would you see any risk more broadly, whether it's currency or otherwise, whereby because supply and demand is coming back into balance, sometime during CY 2023, that there is some risk rather than getting price increases, that we might be in a situation where prices actually start to move lower?
I think first, about our price policies, really, we when there's a cost increase like components among other, we do like, some, I mean, take some ourselves, and then some other we probably have to pass to the customer partner. Even with like a price inquiry, we still lead in the industry on the price performance, on the function, on the service. That's where so far we don't see we lost deal because the pricing, and actually we keeping gaining market share because we have a leading price performance, especially in a lot of what we call the convergence area and also like SD-WAN, OT, these are one of our fast-growing areas. It's all our price advantage compared to competitors.
also we do see a lot of a potential to drive additional service because our service charge probably average about half of what some of competitors charging. some of them offer free, some of them we charge less, some of them sell as a bundle. we do see a lot of potential growth area in the service, which also have a higher margin.
Okay. Thank you.
Thank you. Okay, just pulling up our next caller. It's Gregg Moskowitz from Mizuho. Greg, please go ahead. Your line is open.
Okay. Thank you for taking the questions. Keith, I know that you had experienced a bit of a pause in the first 10 days of June. With that in mind, how was linearity in the Q3 period? Were there any air pockets or anything that you would call out?
Yeah, I don't think we didn't see anything like we saw. Good question. We didn't see anything like the two-week pause or 10-day pause we saw the first part of June into Q3. I think that, you know, when we look at linearity, you know, you can see the DSOs, and I think that's a pretty good reflection of where we're at with linearity. You know, it has not and probably will never be a one-third, one-third, one-third business in terms of linearity. You're always gonna get about 50% of your business in the final month of the quarter. Nothing really unusual about the activity there.
Okay, thanks. Just as a follow-up, you know, quite a few questions about that billings guidance for the Q4. You know, you outlined earlier to, you know, in response to Brad's question, the calculus that's sort of going into, you know, the Q4 guidance and, you know, the prudence with respect to the possibility for sales cycles to be elongated. I did just wanna be clear though, on that point. As it relates to the Q3 period and perhaps even the month of October, are you seeing any changes as it relates to average sales cycles?
We still have a very strong pipeline, actually stronger than before. At the same time, we built a pretty healthy strong sales capacity to meet all the demand. Keith mentioned some tenure. Like, we have about 50% of sales force actually has not reached their tenure yet, which we believe will become more productive in the next six to 12 months, which also will help drive both the top line, bottom line.
Just so I don't confuse Ken, because I've already done that, so tenure's up about 50%, tenure people. We didn't have, give him the mix number, but it runs about 30% of the mix. It's a significant number of people that we increased that are starting new to the organization.
That all makes sense. I'm just wondering if there were any changes perhaps that you noticed that might've been macro-related affecting sales cycles over the past three to four months or so. If possible, it'd just be very helpful to get a brief commentary on that as well. Thank you.
Yeah. I just think that, as I said earlier in the conversation, as we started to see some our deal sizes getting larger in the enterprise, you know, we're certainly subject to more inspection perhaps than we, you know. But the eight-figure deals are certainly subject to much more inspection than the seven-figure deals were.
Yep. Okay. Makes sense. Thanks, guys.
Standby for our next question. Adam Tindle at Raymond James is our next caller. Adam, your line is open. Please go ahead.
Okay, thanks. Good afternoon. Keith, I wanted to start, appreciate that you gave a little bit of color on 2023 on services growth acceleration, obviously an exciting catalyst. I think, you know, the flip side of that is we're just kind of really unsure how to think about puts and takes to the other line item on product revenue growth. Not asking obviously for specific guidance, but I'm thinking about these tough comps. You know, you just had very strong growth on one of the toughest comps that you've ever experienced in Q3. Your exit rate billings guidance is coming down. I think there's worry that the cancellation rates are at 4%, but could that ultimately increase with supply chain visibility?
A lot of fear on how bad product revenue growth could ultimately be, and certainty on services revenue growth. Anything you could maybe point us to for a realistic view of how to think about puts and takes to product revenue growth in 2023.
Yeah. Kind of covering some old ground here. I don't mean that negatively. You know, one, I would just, again, the fact that we reiterated the midterm guidance, which is a 22% CAGR, is probably a good indicator of how we think about it. You know, I think that, you know, investors and analysts and ourselves are trying to understand, you know, the timing of when the backlog is gonna reverse, you know, and actually go through the income statement and have an impact on product revenue. You know, and it's gonna provide. When it does happen, I think it'll provide some elevated product revenue numbers, as we look forward to it. Yeah, I don't. I had another point to that, and I kind of lost my train of thought. I apologize.
Yeah. The growth driver we feel is not changed. Like the convergence, like all the consolidation also elevate like a certain environment. That's how we're keeping driving the product growth and also the service also. I think the product revenue is usually the leading indicator of service revenue. It's a pretty strong product revenue growth in the last two to three years. We do see the service revenue continue to improving.
Yeah. I would come back and just talk a little bit about the cancellation rate comment that concern. Again, it has been remarkably consistent at 4%. Not suggesting there's something there that would be a challenge. Certainly I think the firewall part of that, you know, which is roughly one-third, is probably very specific to us and not really a commodity. You know, there's other metrics that we've provided in the past, and we can certainly kinda go through them again. You know, over 90%-95% of all backlog is with existing customers. It's not as if there's people coming off the street and trying to order from us because they're trying to double order or something like that. That's just not plausible about it.
Of what's in backlog, I think, again, over 50%, and I'm looking at Peter to nod along that he agrees with me, that that has been partially delivered, so it's unlikely they're gonna cancel something. You know, as backlog got older, you know, do we have more concerns about it? We were actually aging a little bit. Yes, we did. Now we're starting to see, you know, a bit of a plateau here in terms of what the backlog increases are and sort of some easing around too, could be on the horizon around the supply chain environment. While we do watch the cancellation rates, you know, very, very closely, we are not seeing indicators of concern there.
Yeah. I think one other statistic that I, if I'm recalling the numbers correctly, I'm gonna have to look this back up, but I think the top 20 deals in backlog account for, like, 8% of backlog.
Yep, that's what it was.
Yeah.
Yeah.
Got it. Maybe I can sneak in a quick follow-up, just to get all the fear out there, because, you know, after market moves suggest there's a lot of fear. On, from a billings basis, you're mixing towards larger deals, which is obviously a good thing for the business, but your average contract term is flat at 29 months. A number of software companies are seeing durations decline, in particular on those large multi-year deals. How do you think about, you know, potentially controlling for this so that duration doesn't become a headwind to billings growth? Thanks.
Yeah. I think we've said for several years that as we continue to expand into the enterprise segment, we expect that that's gonna bring with it longer term contracts. It has shown that. If you go back
A couple of years, I think average contract rates were closer to 24 or 25 months, and you're seeing that continued pressure. I absolutely continue to believe that as we continue to have success expanding the enterprise, and that continues to be a larger part of our business, it will continue to put a bit of a tailwind, if you will, on average contract term. I think also SD-WAN has shown to clearly be a longer-term contract that when customers come to the party. We're not seeing that. I'm happy to see the last few quarters that we've kind of been at that 28%-29% month, and staying at that level. I was actually a little concerned that it was gonna continue to grow and get into the low thirties.
Thank you.
Okay, we have our last question for the session. Michael Turits at KeyBanc. Your line is open, Michael.
Thanks. To the extent you can you talk about whether or not it seems realistic for backlog to continue to rise after this quarter? Is that the point you think that starts to go down? At a fundamental level, where do you think we are relative to demand and if you will, you know, a refresh cycle around data centers that may have been neglected during COVID?
I probably will not using the refresh, because I feel in the last, like, a couple of years, it's some change in the network security landscape. I probably more using the convergence, especially we see the strong growth from secure SD-WAN, OT, and also, internal segmentation of the data center security, which security suddenly deploy into the position traditionally network security not deployed. That's actually, we drive most of growth from that area. We do get into some big enterprise. They're also looking at, how to, do the consolidation, like, whether networking security working with the other part of, the infrastructure security there.
We also see a very strong growth for business in the big enterprise there also. That's probably not the time to really deploy into the new area. Not only the environment is rather fast and also a lot of, like, working from home remotely, but also a lot of new area drive a lot of new deployment. That's where probably we're not kinda looking to refresh, replacing some of the old network security devices, but it's more in the new area we see will be driver growth for a very long time in the next five to 10 years.
Keith, on backlog?
I'm sorry, on backlog?
Yeah. I mean, you know, consistent with whether
I think the last quarter and maybe we'll look in the fourth quarter. The inference would be that we're at a bit of a plateau.
Still gonna depend on supply, though, which is still a dynamic, right?
Yeah.
Thanks.
Okay. At this time, I would like to turn it back to Peter Salkowski, Vice President of Investor Relations for closing remarks. Peter?
Thank you, Eric. I'd like to thank everyone for joining today's call. Fortinet will be attending investor conferences hosted by Barclays, Stifel, and Wells Fargo during the fourth quarter. Prior conference webcast links will be posted on the events and presentations section of our website. If you have any follow-up questions, please see the presentation from yesterday. Thank you very much.
This concludes our program. You may now disconnect. Thank you.