Fortinet, Inc.
Q1 2012 Earnings Call Transcript

Published: 25 Apr 2012

[Operator:]

Good day, ladies and gentlemen and thank you for standing by and welcome to the Fortinet Q1 2012 earnings announcement conference call. (Operator Instructions) As a reminder, today's conference may be recorded. And now I will turn the floor over to Ken Goldman. Sir, the floors is yours.

[Ken Goldman:]

Great, thank you and good afternoon for all of you joining us for this conference call to discuss Fortinet’s financial and operating results for the first quarter of 2012. Joining me today are Ken Xie, Founder, President, and CEO; and Michelle Spolver, Vice President of Corporate Communications. In terms of structure of the call, I will begin with a review of our operating results before I turn the call over to Ken to provide additional perspective of the performance of our business. I will then conclude with some thoughts on our outlook for the second quarter and full-year 2012 before we open up for the questions. As a reminder today, again we are holding two calls. Following this call, we will hold a second conference call to provide an opportunity for financial analysts and investors to ask more detailed financial questions. Second call will begin at 03

[Ken Xie:]

Thank you Ken and thanks to everyone for joining us on this call. The first quarter marked our strong start to the year for Fortinet with continued demand for our core products and growing market acceptance of our recently introduced products. As Ken noted we once again exceeded across all finance metrics including billings, revenue, profitability and cash flow. Our results show the investment we have made in our global sales and R&D organization are paying off. In addition to deliver innovative market leading products we are further penetrating key large enterprise across all regions and continue to grow our position in the high and the low end security market. While business is being driven by continuous robustness in the network security market fueled by following trends, first the requirement for high-performance loan agency security is increasing, our custom developed FortiASICs and the FortiGate System enable us to deliver unmatched performance with recent onsite testing demonstrate on RSA confirming that Fortinet has the world's fastest firewall secure over 500-gig of real application traffic which is 3X faster than our competitors. The processing power boost we got from FortiASIC and FortiGate system is a significant performance advantage and the prime reason why we are growing well in the large enterprise service provider market. Another trend is the integration of multiple security functioning to a single unified path form for ease of management and better security. Fortinet as a pioneer and a leader in this UTM space continues to lead and benefit in this trend. The UTM market is becoming one of the biggest and fastest growing segment in the network security space and Fortinet has continued to gain market share with our product and technologies. Finally the trend is towards delivering cloud-based managed security service by telco is seen continually. Our FortiGate-5000 system delivered highest performance, better unified multi-functions, virtualizations and very good features set Fortinet apart from competition and enable us to win large deals with new and existing Telco and service provider customers. So one of the example is one in Q1 was a six-figure deal with existing customer who is one of the world's largest telecommunication provider. This telco is expanding its large Fortinet deployment and has in fact the FortiGate-5000 system and FortiManager and (inaudible) to serve as the technology platform to deliver new cloud and customer premise based management security service offering to a customer within the region in EMEA. So during Q1 Fortinet made acquisition of (inaudible) commodity based neutral guard device which gave us technology and talent in the DDoS base. Early today we are now the first product resulting from this acquisition, the FortiDDoS-100A, 200A and 300A appliance which expand our network security performance and detect and protect against a DDoS attack. We will be expanding this product line with additional next generation DDoS product targeted for release in the second half of this year. As I have said in the past, we are proud of our product and quality and so the product certification and test are important for addition in this market. So during Q1 we achieved a common criteria EAL4 for our FortiOS 4.0 operation system and now 16th consecutive VBSpam award. Additionally our FortiGate-60C was awarded best UTM security appliance in SC Magazine 2011 Readers' Choice award. And FortiGate-5000 achieved award FortiOS as the firewall performance of more than 500-gig real traffic application, real application traffic in the test performance performed by the BreakingPoint lab. So Fortinet hold most certification than any other security vendor and we intend to keep and maintaining this position by delivering high quality and superior functionality that is validated through the (inaudible) certification. So we have an exciting technology roadmap. With the new FortiASIC and our new FortiOS 5.0 operating system coming out later this year, that we believe would drive our competitive advantages in the way of performance and functionality even further. So this long with the healthy network security environment making us confident that our ability to continue to grow and gaining market shares. So now let me turn the call back to Ken Goldman who will give us the finance outlook for Q2 and the rest of the year.

[Ken Goldman:]

Great. I will do this relatively quickly and you can see the guidance on slide number 13. Let me remind you that guidance does consist of forward-looking statements and keep in mind my earlier comments regarding such statements. Let me talk first to second quarter. It is expected to be in the range of $136 million to $140 million which at the midpoint represents growth of about 25% year-over-year. Total revenues expected in a range of about $123 million to $127 million which at the midpoint represents year-over-year growth of approximately 22%. Gross margin is expected to be in the range of 73 % and 74 % as we continue to invest in our support organization as well as the expected higher mix of products, it takes into account the continued investment in our support organization as well as the expected higher mix of product with services revenues. Non-GAAP operating margin is expected to be approximately 23%, up slightly from Q2 of last year given the investments in sales and R&D. We see some room from operating margin improvements later in the year which is reflected by our full-year operating margin guidance of approximately 24%. Non-GAAP earnings per share expected approximately $0.12 based on expected share count in the range of 166 million to 168 million. Free cash flow of $35 million to $40 million as the Q1 AR balance is $11 million lower than the Q4 balance that we started with much a lower beginning AR balance and this does take in account the significant overachievement that we achieved in Q1. Pro forma tax rate of 34% up from 33% and again that's through the exploration of the R&D tax credit so far. In terms of the full year we are increasing our guidance for the full year based on the strength of our first quarter as well as a healthy business environment that we see at this time and thus to expect billings to be in the range of 580 million to 590 million, up from our prior guidance of 565 million to 575 million. At mid point puts us approximately 23% growth for the year based on expectation to further gain market share during 2012. Total revenue would be in the range of $515 million to $530 million, up from $505 million to $520 million that we previously provided. This midpoint puts our growth rate at 21% for the year. Gross margins would be in the range of 73% to 74% and operating margins will be around 24% for the year. In terms of EPS, we expect it to be in the range of $0.49 to $0.53, up slightly from the $0.48 to $0.52 we gave prior and based on our expected weighted diluted share count of approximately 167 million to 170 million. Free cash flow is expected to be in the range of $160 million to $170 million, although the range is the same, it is expected to be up by $10 million from our previous adjusted free cash flow guidance as we estimate the excess tax benefit impact to be approximately $10 million for the year and again we are not splitting that now. So it’s important to note that we are still a little bit more in the quarter and to the year and as we have in the past we will continue to update you as we proceed through the year. So with that, let me now turn the call over to the operator. We will take your questions and answers. We will give the answers to your questions.

[Operator:]

Thank you sir. (Operator Instructions) Our first question in the queue is Michael Turitz with Raymond James. Your line is now open. Please go ahead.

[Michael Turitz:]

I got a couple of questions, one, I don't know if I missed it, but was there, where there one or several very large deals in the quarter?

[Ken Goldman:]

No, I didn't talk about any particularly large, large deals. We did have a number of deals that I noted over a million, but with no specifically large deal that I noted.

[Michael Turitz:]

Okay, so certainly nothing in the $10 million or more range?

[Ken Goldman:]

I wish it.

[Michael Turitz:]

And then just I would like to figure one of the current doings, if I recollected that or just kind of look at your -- just like the change in current deferred it seemed a little bit short in terms of growth rate, but as far as I can tell its also a tough comp, right?

[Ken Goldman:]

Well, I don’t know, I look at it, I mean the deferred revenue obviously is a base line where do you cumulatively during last year as well; what I am really look at is the growth in billings which case in account the growth in deferred plus revenues so that’s how we get the billings.

[Michael Turitz:]

And then just one question on that adjustment free cash flow or get off the free cash flow; you said that it’s $10 million more because you are not adjusting but was there an offset on amortization so, but also an offset to the delta there?

[Ken Goldman:]

We kept the amortization the way we’ve always done in the past and so effectively the way we’re doing to free cash flow this quarter and going forward is exactly same as we have done prior to Q4, there is no change.

[Michael Turitz:]

Okay. Great, thanks very much guys.

[Ken Goldman:]

We listen to a number of analysts that’s out there to make it simpler and not do a lot of permutations if you will.

[Operator:]

Thank you, sir. The next questionnaire in queue is Keith Weiss with Morgan Stanley. Your line is open.

[Keith Weiss:]

I was wondering if you could dove into the impact of those multi-year mid-range bundling or maybe just help us a little bit more what that’s about sort of how that firstly comes in the balance sheet and then a one follow-up?

[Ken Goldman:]

Well, basically what happens is, in terms of -- two different things, one is when you do a new deal, it includes service and non-service and it may include one year, it may include multi-year and so the extent you do more deals with service contracts, you renew it for multiple-years. And so you tend you do renewals; our original deals with multiple years of services involved and across just one year, you have a great component of that which is rated to deferred, as opposed to upfront type revenue.

[Keith Weiss:]

And then on that slide, you noted or you did a, if you excluded that impact high end, did the high-end SKUs dealings would have been 35%, would there also be a comparable effect on the low-end SKUs?

[Ken Goldman:]

I think we did it directly for all SKUs, so with comparable data and basically we did it, whereas we just look at hardware product revenue how it looked, and so you didn’t look at billings for the point of view of services, you just look at product revenue hardware revenue until it would look like the number that I showed you.

[Keith Weiss:]

And then on each of the hiring side, it looks like your hiring picked up; the rate of growth in headcount picked up a little bit, can you give us little visibility into where you guys think you are in terms of sales capacity, how comfortable you are and maybe some view on how you continue, how you see headcount ramp for throughout the remainder of this year?

[Ken Goldman:]

I would say it this way; we do feel that collectively as a company, we are doing a better job of hiring overall. So whether it’s in sales or R&D, let me take R&D first. We think we have done a better job of, particularly where the bulk of our folks are in Canada, Vancouver and so forth. We’re doing a better job of hiring up there. Better job here as well. Sales, it’s no one region, it’s pretty much we are increasing across the board and again I think there we are much more well known, we’re placed to come too so to speak from the security point of view. And so I think in general our hiring has improved in terms of our capability. To the capacity I always take as part of headcount we always estimate in terms of how much more we sell, I would say that we feel very good about the success of the sales force overall in terms of making their goals and we will continue to bring on more capacity if you will as the year unfolds. Ken wants to add some.

[Ken Xie:]

In order to the recent trend for all the cloud, for all the bigger data center and how this also help us to grow in there -- I think we have much better performance products and this cloud trends and also the datacenters is really helping the business also.

[Keith Weiss:]

And secondly one last one, in Q1, I believe you had a transition in your user distributor, you brought on new distributor; any impact from that transition or does went relatively smoother?

[Ken Goldman:]

We are in a new chase, I think this year we did have some changes if you are referring to last year, and as you know I pointed out the fact that we had as well in Southern Europe we had good growth in the UK as well and so we actually pointed out a lot of deal we had in the UK. So we are seeing improved results there; our team has come together and as I said last year we had to make -- we thought we had to make the adjustments in our organization to improve and that’s what we’ve been doing.

[Operator:]

Thank you, sir. And our next questionnaire in queue is Rich Sherlund with Nomura. Your line is open. Please go ahead.

[Rich Sherlund:]

I would like a follow-up on the question of large deal; is there anything you can show that’s in the pipeline that looks at the magnitude that was adjusted previously in terms of very large build?

[Ken Goldman:]

I am not sure Rick I can fully understand when you say adjusted I am not sure I followed that. We don't intend to talk too much about pipeline going forward other than how it impacts our, how we take into account that for our guidance.

[Rich Sherlund:]

Yeah, I guess I was just talking about $10 million deal or anything in the pipeline of that magnitude?

[Ken Goldman:]

You know we don't tend to you know I don't think we have ever done a deal of that magnitude here. We did a one large contract which over a number of quarters will equal that kind of a number. But that's over a number of quarters as opposed to one quarter’s billings or revenues. And with that $10 million deal that it would affect one quarter in terms of end user customer.

[Rich Sherlund:]

Ken was that not this past quarter but that was done previously you are saying.

[Ken Goldman:]

This was last year. That was this period last year.

[Rich Sherlund:]

Okay, and might we see something similar to that this year even though it's not you know one deal.

[Ken Goldman:]

Nothing that I can really talk to at this point.

[Rich Sherlund:]

Okay, Ken just to come back to the short-term deferred revenues, I mean to the degree that you had such an outperformance in the total deferred number, is there any ability that you have to kind of decide how much business you are taking in, on the short term deferred side to kind of manage the growth of the business.

[Ken Goldman:]

No, actually it's not really how you know how it's done I mean and even the fact that short term versus long term that is, it just happens to be the kind of business that we might get in a particular quarter, the types of contracts that we get and it's not something that happens per se at the end of the quarter. It's much more sensitive to the customers and their particular demand in any one quarter. There are certain retail customers that frankly do like the ability to walk in their pricing and their cost over a period of time and frankly they like to get the billings done so they can lock it in. So we will see some customers that prefer that but as I said before we’ve had some other quarters where long-term deferred hardly budged it out and so it is a little bit arbitrate, so I don’t want to get people excited at one quarter so it makes the trend because it sort of it goes by what happens in a particular quarter. I would also add that we tend to see some higher renewal opportunities in Q4 and Q1 and tend to scale back a little bit from a seasonality point of view in Q2 and Q3 and we take that in account in our billings projections.

[Operator:]

Our next question in queue is Sterling Auty with JPMorgan. Your line is open, please go ahead.

[Sterling Auty:]

Strong billings results specially in light of what we heard from CheckPoint, looking at the mix, it looks like mid range was strong but I am kind of curious, was there any softness whatsoever maybe to start of the year in enterprise or do you think the demand was consistent?

[Ken Goldman:]

Now, I think it was actually very consistent deal, we had a very strong enterprise business in Americas in Q1 in particular and so no I think the you know some times from the types of product we may sell from customer to customer can change, from a little enterprise and particularly to the extent that we have you know it can a little adjusted by the mix but longer term bundles, but if you look at the hardware and the deals that we originate during the quarter our enterprise was quite strong actually.

[Ken Xie:]

He is actually right. The meter in the product, the 300C, 600C we introduced in Q3, Q4 last year, so this started to ramp up, so we are continuing to introduce the new product later this year.

[Sterling Auty:]

Okay. And then I heard the competitive win case studies, but given (inaudible) and registration for an IPO can you just talk about competitive landscape against them and may be then broaden it back out to the whole segment?

[Ken Goldman:]

(Inaudible), I always come back to the overall point that our particular market is a growth market. There aren’t a ton of competitors. There are a few competitors there and I think overall, yes, we are overall gaining share but I don’t think, well always like you say this is not a zero submarket that we are in and so I am not going to say anything negative frankly about anybody at this point.

[Ken Xie:]

On other side, I think as well we try to develop technology, the basic technology more targeted long term like from ASIC share from all this integrated module functioning of FortiOS and also we have much broad geographic coverage like all this three region and also more vertical coverage and I think that I believe is really the basic turnout. We develop, contrive this growth long term compared to just a few segment and also does some and try to boost the sales by like a lot of spending in some few area. The other thing really from all the analyst reports surely the UTM, the multi function, the market keeping, growing more fast and so we are really the pioneer in this space and the firewall IPS combined that is the called the next gen firewall at the subset. That's confirmed by a few, quite a few research firm. So we do see this as a trend that integrate multi-function solution is really the customer see the benefit of it and so we feel we have a good platform, we can add additional performance beyond the CPU can do and also the multi function, we develop and integrate together, it is also being in the market for ten years, for more than ten years. So we see is a huge advantage we have.

[Ken Goldman:]

I think in terms of actually the opposite of some of the questions I think you know we are benefited by the fact that we are not reliant on any one major deal like to a million dollar deal. In the quarter we have -- you know we ship thousands and thousands of units in the quarter to thousands of customers and so we are very well diversified geographically, both across the globe as well as each of the regions themselves, so we have a very broad based sales force, very, very broad based product portfolio and in some areas there and typically some of the midpoint areas that we do want to increase some shares, so it isn’t you know this is certainly again, pin or check or whatever but there is a whole host of opportunities up and down the board that we see we can grow.

[Operator:]

Thank you sir. The next questionnaire in queue is Walter Pritchard with Citi, your line is open. Please go ahead.

[Walter Pritchard:]

Ken Goldman I am wondering just on the trend around the long-term deferred, did you see that trend with longer-term contracts across all geographies and product lines or was that a fairly isolated trends with certain deals and certain types of contracts?

[Ken Goldman:]

I am guessing a little bit on older America but that delivers I get lot of heads nodding in this room here so I think I am safe to say that but I don’t see the reason I am hesitating is that we don’t have that specific gain in front of me but when I think some of the things that caused I think it is primarily Americas.

[Walter Pritchard:]

And was there something you did in terms of – you just in bundling, was it more of a pragmatic bundling or was it bundling on specific deals that drove that?

[Ken Goldman:]

No what it is as I said before it relates to customers in particular a certain number of customers that prefer longer-term bundles because again and again it does not necessarily consistency in this, but in this particular quarter, they prefer -- we want some deals in which they prefer to do longer term, three, four or five-year kind of arrangements as opposed to just one year arrangements, and obviously to the extent you do that, you only take the upfront revenue for the product and all the rest of that bundle is deferred.

[Walter Pritchard:]

Got it and then just, I just related it to your guidance, you raised it, you know your long-term was about 10 million more than you thought you raised the guidance for the year by about that or slightly more. Do you expect that that trend continues through the year or is that something that you think by your guidance going forward, you don't really try to forecast some trend?

[Ken Goldman:]

Yeah, I don’t want -- I always said I don't want to get ahead of myself. So or ourselves I should say. And so, you know, what we did is we basically took Q1, took that outperformance, extended it out and you know, I think it’s still early in the quarter. You know, we are watching our business but we are also trying to gauge the environment that we are in and where other competitors are seeing and so forth, and so this is the best field we have at this point in time.

[Walter Pritchard:]

Great, and then just one for Ken Xie, around the competitor landscape, you know, Cisco, the one maybe you touched on but they have reported that their security business is now growing, I guess, double-digit the last few quarters. I am wondering if you've seen any change as they are the largest players in this space.

[Ken Xie:]

I think Cisco, the way they kind of measure maybe it changed to non-wire, consisting in a security space. So we don't have a much detail but some other feedback we got from a field or some analyst really, the way they measure probably is different. So, I think overall the feedback is really their security has been kind of flat.

[Operator:]

Thank you. Our next question in the queue is from Erik Suppiger with JMP Securities. Please go ahead. Your line is now open.

[Erik Suppiger:]

First off, on the free cash flow, if I look at your fiscal ‘12 outlook, you are projecting basically down -- the future quarters are down from the Q1. What would cause free cash flow to decline from these levels?

[Ken Goldman:]

Well, a couple of this. One is, you know, we exhibited roughly a similar pattern last year. Again, you get the improvement in Q1 from the ability to work office you will, the AR balance and particularly this year, you know we had a reduction in DSO, I think, three-four days from Q4. And it was accounted for 11 million decrease in AR. We’re assuming AR over the rest of the year will be going up and so that will be a source of cash. And that’s probably the primary driver over and above everything else because you know, if you look at pre-tax income, you know that’s goes up but not dramatically. So the AR can really drive a lot of our balance in terms of our numbers. So that’s how we see it. Historically, Q1 is a good quarter for us from a cash flow point of view.

[Erik Suppiger:]

Okay. So the idea that it comes down in Q2 and then it starts gradually growing from there to the second half?

[Ken Goldman:]

Yeah, hopefully.

[Erik Suppiger:]

Okay. Secondly, Dell’s announcement to acquire SonicWall. Does that make any difference to you from a channel perspective or has there been any implication there?

[Ken Xie:]

I think Dell’s probably has a little conflict with some of the channel partner in the DMR space, the direct market retail space. So that’s probably some of the channel gave us a feedback. I think it’s still early to say but it is, probably, sometimes that a dedicated security company becomes a part of the larger wider network company. Sometimes, they may slow down on the product innovation, or some other focus in the security space.

[Erik Suppiger:]

Okay. And then on the OS, I think it is 5.0 and the new A6. When will those be released? You said later this year. Is it any more clarity on when those will be released and when they might start generating revenue ramp?

[Ken Xie:]

I think that’s for us really and we like a straight four years, we have a new major FortiOS release. So it’s time pretty much towards the second half of this year, and so that’s what OS is really. But we don’t generate revenue from FortiOS operating system, FortiGate system, that the FortiOS running on. That’s probably the product we’re selling. I don’t see that will have much impact on other side. Every quarter we release kind of a new FortiGate system, keeping the refresh upgrade. So that’s where the system, just like any other network device, after about, I think, four-five years you need to have the new generation which is faster, which also kind of have a better technology to put in there. It is the same scene for the FortiASIC. So we have three FortiASIC families. 100 Quantum Processor, the other 100 a network processor in there and also the system chip. So that’s where --It takes average about two year to build a chip. So that’s where the FortiASIC chip will be starting built in the new FortiGate system later this year.

[Erik Suppiger:]

Okay. And the ASIC, is that in tandem with the new OS?

[Ken Xie:]

I don’t think it is much related because FortiASIC is gradually working with FortiGate System. So FortiASIC probably, honestly the benefit after we release the FortiGate system and the FortiOS is really the function can be upgraded to all the current FortiGate if the customer bought a service. So it’s a free upgrade for the customers if they subscribe the service or this is -- So, its two different differences.

[Operator:]

Our next questionnaire in queue is Brent Thill with UBS. Please go ahead. Your line is open.

[Brent Thill:]

Just the third quarter in a row, your billings has accelerated and your guidance looks pretty strong for the second quarter as well. I am just curious, it seems like there is a combination of factors but if you kind of short list it in terms of what you are seeing that’s that you think is contributing to what’s happening here and put anything in context for us?

[Ken Goldman:]

Fair comment. I will give you some thoughts and sure Ken will have his thought as well. But I think we are getting the benefit of a very stable sales organization that continues to sell a greater and broader product portfolio. And so I think, one of the things I am saying that I think others aren’t necessarily doing. We are trying to keep things as stable, consistent as possible, whether as we marginally increase our products. As Ken noted, we acquired companies but we do a pretty good job of slowly integrating them into the sales force. We manage the quarter achievement and I thought -- I think in a thoughtful way. And our markets overall are healthy such that you have more and more customers that understand the benefits of UTM, and I think some trends are going in our favor, related to UTM, and related to mobility, related to virtualization, and the brand awareness of Fortinet even though it’s not where we would like to be in. It continues to improve. So, I think we have lot of those things in which we are keeping things stable and consistent as possible and adding on as oppose to taking a detour. That that’s how I see it anyway.

[Ken Xie:]

Yeah, I think its probably three major areas, the first is really our internal execution, hiring now and it just seems I think we keep improving. The second part is really related to the big market environment, I think the security space, right now the security space really keeping growing and it’s our healthy space and I think its overall because all this new trend whether it go the cloud or the mobile device, or bring your own device to work environment and they demand more network security and so that's basically the big environment also are healthy. And the third part really, the long-term focus to develop some basic technology whether from a chip level, from OS level, from other function level and also the way we maintain the quality by (inaudible), so that's what starting to pay off and that's also what's keeping investment in this area. So I think it’s always a sweet trend and is kind of helping us keeping growing for us really, we want to focus more long-term if that particular space or some function and try to boost by some kind of opportunity. But really keeping investing, growing long-term and eventually we want to make some difference in the space.

[Brent Thill:]

Real quick on Check Point with the 61000 series they launched last summer, have you seen it show up and you could keep it to a simply yes or no?

[Ken Xie:]

I think that’s the product probably more towards the server market, but I feel still its a little bit different approach than we have. We feel the level of security really need to design from a network point of view from the chip with the system level is that just leverage the CPU to server. And I think it’s a good product, but on the other side for us we still feel we need to launch more long-term investment on the basic technology to have the future much better product going forward.

[Operator:]

Thank you, sir. The next questionnaire in queue is Robert Breza with RBC Capital Markets. Your line is now. Open please go ahead.

[Robert Breza:]

Hi, most of my questions have been an answered, but I guess Ken Goldman could you talk a little bit about some of the vertical contribution you mentioned retailers as a key vertical, so were there any other verticals that did out this quarter?

[Ken Goldman:]

Yeah, I think service provider, if you look at the percentage was on the higher end and what we’ve been saying. I think education, I pointed out a few educational wins and there is other I can’t think at the top of my head as well. So I think we are doing well in the education, so I think you look at service provider, you look at retail and I think about education some of the areas that I would point that we particularly commented this quarter.

[Robert Breza:]

Maybe as a follow-up for Ken Xie; Ken have seen any change from a deployment perspective across the different verticals; are people starting to quarantine off their network or more; I am just curious to see if you’re seeing people change kind of the design of their network do you think? Thanks.

[Ken Xie:]

I think under the price environment probably starting revisiting how they went to secure a lot of our whether mobile device or some other thing to go to the cloud, so that’s probably because some high-speed and also a multi-function device. And also we’re also trying to kind of simplify the security management because otherwise they have to deal with many different vendor and it is also sometime can be too costly or kind of too difficult to manage. Other than that and also since internet started growth kind of pretty much everything using leverage internet and our application also kind of go over internet, we also see some kind of demand in our SMB and also in the emerging area like APAC, so you can see the APAC region also growing pretty fast in the last quarter. So we see a lot of new deployment going on there, lot of new inputs going on there. So that’s probably a few things we see.

[Operator:]

Thank you, sir. The next questionnaire in queue is Jonathan Ho with William Blair. Your line is open.

[Jonathan Ho:]

I just wanted to start-out with may be the datacenter space, are you seeing sort of an acceleration in terms of opportunities for a security there or any change in terms of that opportunity?

[Ken Xie:]

Yes, I think that a lot of datacenter being build right now because all these due to the cloud, out of service based approach. But initial skill that the secured gateway seemed much, much slower than the networks which can deliver in the datacenter probably even 10 times lower because we think it’s really security gateway process much more. They need much more processing power because they had to go deeply in the pack of audience, competent audience switching to deliver the trophy there. So that’s where today, with still a lot of our low percentage datacenter has any kind of security on the network side, so that’s obviously a huge gap, that’s making kind of network security interesting is really a lot of huge datacenters do too fast for a secured device to even secure it right now; it’s still quite a low percentage and that the space deal are huge.

[Jonathan Ho:]

And just in terms of your vertical strategy, I mean you guys touched a little bit on that but I just want to understand you know how much of a difference is that making as you are targeting the specific vertical does this accelerating your growth or helped your win rates; just trying to quantify or understand you know how much of a difference that’s making?

[Ken Xie:]

We do see a service provider going well because that’s we are starting using value added service and even some other parts leverage service provider to security offering there. In other new area I think that’s probably as we have mentioned in the past one or two years, we’re starting to divide cells into the vertical space like Ken Goldman mentioned early, so we’re starting to build healthcare team and the finance service vertical space and the education space. So that does start paying off because some time these vertical space deals take a little longer time compared to early days we have more regional based sales force. So that also drive us to the bigger deal, so that’s the area we see kind of gradually gave us more kind of bigger deal there. On the other side is really I mentioned some of the international region APAC or some other and you will be studying how we have good recovery there and also APAC we are starting to see some good growth there.

[Jonathan Ho:]

And just one follow-up if I may how does the common criteria certification expand maybe your government opportunity open-up some doors for you guys?

[Ken Xie:]

We just want to set high standard and make sure to quote out ever since really for the highest quality, we are going to hear about but also ISO Certification and some other certifications we have; not only the company, not only benefit government, but some other big enterprise, some other government outside US also from time-to-time to use as a standard to measure different vendors. So first like we say, we maintain the highest number of certification among all these major security vendors. So we want to continue to invest in this area because it's difficult for various enterprise or some, even some government or some other customer to test how secure each vendor's product is. So that's where the third party certification is the best way to validate instead of each vendor try to market, over market to promote themselves. So that's where the third party certification we view as a way to maintain our high quality and that's where each function we try to go all the major certification in that particular space whether it's firewall, antivirus or intrusion or antispam and at the same time and others like ISO, the (inaudible) and SIP's certification and also the [NAPS] navigation with telco, I think we maintain a lot of certification and thus try to keep a high quality for the product.

[Operator:]

Next questionnaire in queue is Aaron Schwartz with Jefferies.

[Aaron Schwartz:]

Good afternoon and congratulations, I just had a question on these retail deals, I know you had a big one in Q3 and another one here, you know it seems like you have a nice little sort of franchise in that area and maybe because your broad based product portfolio is well as suited for the large deployment there, but can you just talk about sort of how that deployment works, I mean are these you know four quarter deployments or maybe it's not standard but maybe you could just walk us through how that works.

[Ken Xie:]

There's one in particular that we did refer to instead, we won in Q3 of last year which is a large one. That was developed in a way to roll it out over a number of quarters, four quarters or whatever. There are some other ones that sometimes they will do in phases, Phase 1, 2, 3, other times it's you know, it’s a one time, I mean it is initial one-time agreement and then they may buy down the road but there is no commitment upfront as to doing that so. It varies all over the map to the point I mean to the extent where they may do a committed phased rollout to the extent there is a one time but with the idea that we can win future business along the way.

[Aaron Schwartz:]

But the billing work per deployment so as you bill it out on a multi-quarter basis, it's just billed on you know basically a per unit basis?

[Ken Xie:]

Yeah as a fact we had in, the extent that we’ve bill that means we bill, we invoice, we collect and we only count the billing if it's collectible within our normal payment terms and so to the extent that we have a contract over a number of quarters but we can’t, but we can only bill say the first quarter that would be what we count for billings for particular quarter.

[Aaron Schwartz:]

Okay. And then second question from me if I could, on the long-term deferred I mean that you alluded to some multi-year, three, four, five years deals there. Do you collect all the cash out front on those?

[Ken Xie:]

Well yes. If again if it’s a billing that includes a number of years we would not count the billing unless required the cash up front that's correct.

[Aaron Schwartz:]

Okay. So everything in long-term deferred, that’s all.

[Ken Xie:]

It's all invoiceable and collectible.

[Operator:]

Next questionnaire in queue is Scott Zeller with Needham & Company. Your line is open, your question please.

[Scott Zeller:]

Hi, thanks. Just going back to an earlier question for clarification. If we look at page four the slide deck, when you talk about the high end billings contribution, that 31% would be 35%, if we only focused on actual license product sales, is that correct.

[Ken Goldman:]

Yeah. If you just look really at hardware.

[Scott Zeller:]

Just the hardware.

[Ken Goldman:]

Right.

[Scott Zeller:]

And also regarding the high end again could you talk, we’ve had some earlier questions about competition, but could you talk specifically about the largest carriers, the carrier grade products and who you see competitively there and if there has been a change at all?

[Ken Goldman:]

Yeah. I am looking and I don’t think we have seen a significant change in the competitive landscape on service grades. I think that's the business that we continue to as far as we know when the majority share of the business and I think there is a case particularly if you are talking about them as a service provider, manage the security service provider where the UTM product feature really fits their need and so I think there is really no one else that has the ability to really service that to the extent that we do.

[Ken Xie:]

I think for a service provider the three major functions they need, first is the high performance reliability. So that’s also both south region of in the higher platform. So that we have a huge advantage with our customer design ASIC system which is much more reliable compared to some other as a PC server in the higher base and also the NIPS certification, that's where (inaudible) also helps there. The certain part is really, really for the flexibility functionality because for the service provider, so they need to have the flexibility to offer different functions to different customers. And that’s where we have 11 function in the UTM. So in the same box they can turn on, turn of different function based on the customer need and then the third major piece is really the virtualization function. So basically you can have a one system to manage hundred to thousand different customer, each look like they are owner, they own a system themselves. That’s a virtualization we started shipping since 2004. So we are way ahead of any other competitor. This is a sweet major advantage to make us love our good position in this ethical service provider market and so far we don’t see any competitor come close to what we have.

[Operator:]

And next questionnaire in queue is Jayson Noland with Robert Baird. Please go.

[Jayson Noland:]

Thank you and good quarter and mostly follow up questions here. On [D5] and new ASIC, do you guys expect to see any seasonality in the revenue in the back half of this year?

[Ken Xie:]

So far, usually it takes some time especially if you look under, there is a sweet layer since first at the chip level, the FortiASIC and then it is a top layer with the FortiOS, but what is important really the FortiGate in the medium level, so that’s why every quarter we release one or two or three new FortiGate system now reached the better ASIC or better CPU or better other since there. But for us from our historic data we don’t see kind of up and down once we release whether the new ASIC or the OS and it's kind of a – it's more long-term benefit inside the short term like a benefit in a particular quarter.

[Ken Goldman:]

Yeah I think I pointed out is the ASICs tend to get incorporated into the newer products overtime so it is not like a one-time event in which all parts have a new ASIC, that’s one thing. Two is we have a natural progression of new products that we introduce every quarter and so we are not necessarily dependant upon on anyone product. It is the same for operating systems, so we tend not to have the up and down cyclical that you have with bringing out new products and which customers held up and wait for new products, it does not tend to be the way it works here overtime.

[Jayson Noland:]

So okay and thank you and I wanted to follow up on Cisco also, they made a push at RSA and even at their Partners Summit last week and Ken Xie, you said you don’t think they are growing per the industry data but have you noticed anything in the field where they have gotten more aggressive or roadmaps that have made deals more challenging at all?

[Ken Xie:]

We don't see much. On either side, we have kind of probably less compete was Cisco because they are a big networking company, secured as a part always, they are offering some part on the whole deployment, so we don't compete much with Cisco and also we don't see much change in the space.

[Jayson Noland:]

And then last question from me, any update on sales and marketing investment, you talked about that before and it looks like that came up nicely in Q1, the investment level in sales and marketing specifically?

[Ken Goldman:]

Yeah, still primarily in sales; I think we are still working as to how we can smartly increase some of our marketing spending as well, but we did add a number of folks in the sales side and that could increase the sales costs.

[Jayson Noland:]

You happy with the progress there?

[Ken Goldman:]

Yeah I am actually, I think if I look at, in this case I will use the pipeline term, if I look at the folks we targeted as well, with the pipeline that new people we are in process of acquiring, it looks pretty strong and so yeah I think there again as I compare us and I say we are trying to keep things very consistent here in terms of how we attract to retain and motivate the sales organization and I think its working. We have overall a very stable team and we continue to add to it. So I think if anything our ability to hire is better today than it has been.

[Operator:]

Thank you, sir. And our next questionnaire in queue is Phil Rueppel with Wells Fargo Securities. Please go ahead. Your line is now open.

[Phil Rueppel:]

Just a quick one, one of the top verticals kind of remain government and that is one area where we’ve been hearing you know concerns over the spending environment. Are you seeing more budget pressure from the customers in government and do you think you’re still -- are you getting share in that segment similar to some of the other verticals?

[Ken Goldman:]

Yeah, I would say we’re not gaining share in the federal government that is historically not been a strength for us, you know I don’t think we therefore is impacted positively or negatively by the budgetary issues there, but in general you know that’s nearly for us still very modest in terms of results. So when I give overall government result that you see, a small portion of that is federal, a bigger portion is really globally the government business.

[Operator:]

Thank you, sir. Next questionnaire in queue is Brian Freed with Wunderlich Securities. Please go ahead. Your line is open.

[Brian Freed:]

Two quick follow-ups; first, you had a 34% tax rate in the quarter you mentioned R&D tax credit. Can you talk about where you expect that go moving forward? And secondly, you talked about operating leverage incremental in the second half. Can you talk a little bit about what elements of your cost sales R&D gross margin offer the most leverage? Thank you.

[Ken Goldman:]

Yeah, from a cash point of view right now we’re hanging at 34% and we don’t actually like that rate, but it does take into account the lack of R&D credit and we don’t really have as of yet anything that could bring the rate down. We are working on some new organizational structures if you will that might have a mass impact towards the end of the year, but hopefully we’ll have a bigger impact as we get into ’13. In terms leverage, I think gave guidance on gross margin, so I think I have talked to that. I think with leverages, as we grow the business we intended during the year, not to be higher as much in R&D, so I think we will get a little bit of point there and I also expect us to see some leverage in the sales side. It was 33% I believe this quarter and we tend to get down to 31%, 32% as the year unfolds. So I think a little bit both in sales, a little bit in R&D, but nothing dramatic. That would get you from the 21, 22 times of numbers to 24, 25-ish.

[Operator:]

Thank you. (Operator Instructions) Next questionnaire in queue is Alan Weinfeld with Davis Securities. Please go ahead. Your line is now open.

[Alan Weinfeld:]

Thanks guys.

[Operator:]

Mr. Weinfeld, your line is open. Please check the mute button on your phone.

[Ken Goldman:]

Alan, can you hear us okay Alan? Alan, we can’t hear you. We can go to next and Alan can then comeback in or briefly we’ll be here at 03

[Operator:]

Okay. We do have one additional questionnaire in the queue at this time then?

[Ken Goldman:]

Well, we will have as a last question and then we will hold to 03

[Operator:]

Understood sir. Mr. (inaudible) please go ahead. Your line is now open.

[Unidentified Analyst:]

Sure, Ken hi, I thought you were going to keep the party going till 03

[Ken Goldman:]

We got a party, but that’s the way you want to use us great.

[Unidentified Analyst:]

Hey, I guess I just want to follow-up on the, on gross margin guidance that you lowered the range to 73%, 74% versus prior year 74% I ma just curios if it was a mix issue there, if new products have lower yield or nothing specific in mind to your best just simply given yourself more room with the specific in line?

[Ken Goldman:]

There are a couple of things I have in mind, I mean as we really expand the customer base, we are having to increase our support efforts, and so it’s a little bit of a catch up there, and so that’s an area of investment as well. And so we do expect a little bit of a mix shift between products and services to the extent that drove more products and services and that also affects the gross margin. And I think as we brought out, as we noticed the more mid-range products and the mid-range products tend to have a little bit less gross margin than we see on the higher-end products and as the year, the very end of year we often expect to bring up more higher-end products that may help. So frankly it’s a modest change in terms of gross margin, but there are a few factors that I think are important to point out that I do see that progress in gross margin maybe to go down a point as opposed to increasing a point.

[Unidentified Analyst:]

Great, thanks.

[Ken Goldman:]

So why don’t we hold out there; we will close out this party as was called and in about 35 minutes we’ll re-engage for additional questions that you may have thought of to call. So I thank you for bearing with us. We have a lot to cover and we appreciate your time and we will be here in 35 minutes to continue on and so again, thank you.

[Operator:]

Thank you. Again, ladies and gentlemen, this does conclude this session. You may all disconnect and have a wonderful day.