Good day ladies and gentlemen and welcome to your Fortinet Third Quarter 2016 earnings call. [Operator Instructions] As a reminder this conference is being recorded. I would like to now introduce your host for today's conference, Michelle Spolver. Ma'am, you may begin.

Thank you. Good afternoon and thank you for joining us on this conference call to discuss Fortinet's financial results for the third quarter 2016. With me today are Ken Xie, Fortinet's Founder, Chairman, and CEO and Drew Del Matto, CFO. Ken will begin our call by providing a high-level perspective on our business. Drew will then review our financial and operating results and conclude with our forward guidance before opening up the call for questions. During Q&A, please plan to limit your questions to one per participant with no follow-up. As a reminder today we're holding two calls. For those with additional questions, we will hold a separate conference call at 3.30 p.m. Pacific time. Both calls will be webcast from our investor relations website. Before we begin, let me first read this disclaimer. Please note some comments we make today are forward-looking statements. These forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those projected in these statements. Please refer to our SEC filings, in particular the risk factors on our most recent form 10-K and form 10-Q for more information. All forward-looking statements reflect our opinions only as of the date of this presentation and we undertake no obligation and specifically disclaim any obligation to update forward-looking statements. Also please note that we will be discussing certain non-GAAP financial measures on this call. Our GAAP results and GAAP to non-GAAP reconciliations can be found in the earnings Press Release issued a few minutes ago and on slide 11 and 12 of the presentation that accompanies today's remarks. Please refer to the investor relations section of our website for more information as well as the slides that accompany our remarks. A replay of this call will also be available on our website. Note that we routinely post information on the website and encourage you to make use of the resource. With that let me turn the call over to Ken.

Thank you, Michelle. And thanks to everyone joining today's call to discuss our third-quarter 2016 results. Fortinet delivered year over year building growth of 16% and a revenue growth of 22% despite a more moderate global micro [indiscernible] than we saw last year. On the short for our original guidance, we continue to get market share and win important customers. Additionally, we keep our focus on expense management for improved profitability and towards our goal of 20% operating margin in 2020. As we showed a few weeks ago, the contribution factor that will lead to the shortfall were both macro and execution related. From a macro standpoint, some of the issue seems to be secular and some transitional. We continue to see a more moderate spending environment globally and this affects our performance in all three regions. We believe customers are in a digestion phase following two years of elite purchases. Additionally, as we ponder closely with a large enterprise and service provider customer to plan their next generation to secure architectures we have learned they are increasingly being more strategic in their purchases, extending purchase decisions of buying only for what they immediately need. And finally, macro-economic challenges of Brexit in the UK as well is ongoing geopolitical issues in Latin America were also contributors. We also faced execution challenges in those markets that further impact our performance. The full benefit of the sales force realignment commission earlier than this year have taken longer than expected to achieve, primarily as a result of hire newness within the organization. Many sales reps are still ramping and the productivity in North America is less than we would like. We are laser focused on resolving execution issues and remain highly confident in our competitive advantage and our long term opportunity. I continue…

Thank you, Ken. Let me share our financial results for the third quarter, which can be seen on slide 3. As Ken mentioned, Fortinet's billings increased 16% year over year to $347 million. Total revenue of $317 million was up 22% year over year. Our deferred revenue balance increased to $935 million up 32% year over year. This is a trend that has become more pronounced as our mix of business shifts to enterprise and we have more margin-rich recurring subscription and service revenue. We continued to deliver a strong non-GAAP gross margin of 75% which exceeded our guidance range of 73% to 74%. This reflects our focus on driving sales of higher value, higher price and higher-margin recurring revenue streams such as services and virtualized product offerings. From a profitability perspective, non-GAAP operating margin and non-GAAP earnings per share were 15% and $0.18 respectively both at the high end of our original guidance ranges. We remain focused on driving profitability and are on course towards our previously stated longer-term goal of 20% non-GAAP operating margins exiting 2020. We managed expenses well, and if not for the billings shortfall would've delivered substantial progress toward that goal this quarter. Finally, we generated $70 million of free cash flow during the quarter despite our billings and revenue shortfall. With respect to our third quarter topline performance, as Ken discussed, both market and execution issues were at work. We believe we are well positioned competitively in the market and our laser focused on improving the things we believe we can control such as our own execution and ramping the productivity of our sales and marketing investments. We have an aggressive plan in place to address the execution issues in North America which includes -- enhanced and increased enterprise-specific marketing in areas such as…

Thank you. [Operator Instructions] Our first question comes from the line of Sterling Auty with JPMorgan. Your line is now open.

This is Ugam Kamat on for Sterling Auty. Can you talk about any sales execution issues? Could you throw some color on where those sales execution issues actually existed, like were those service providers, were those large enterprises? Any color on that would be helpful?

We have issued realignment earlier this year and we also hired a sales team. Like right now we have, U.S. probably 40% of the sales team has been less than a year on board and at the same time, we also tried to build in a market engine to drive the sales. Like the lead gen, and the branding and the digital marketing and also the match each program. So all of this still needs time to ramp up and that will contribute to the shortfall that we have. I think we are in a much better position compared to one year ago without the marketing machine BDR and also the teams on board and we just need some time to keep improving and keeping execute.

The one thing to clarify is a question I think also asked about what sectors contributed more to the shortfall. It was both. It was probably primarily enterprise, however there were some deals that did not close in Q3 that were service provider deals and you can look at sort of the breakdown of our vertical mix. The service provider came in at 21% which is less than normal. So it was really those two sectors.

Just a follow-up.

You can't do a follow-up. Sorry, we can't. We need to keep the call short. We have a second call you can call back into. Sorry about that.

No problem.

Our next question comes from the line of Gabriela Borges, Goldman Sachs. Your line is now open.

Thank you for taking my question. You have been talking about the changes of macro and the sales force as being factors in guidance for a couple of quarters now? Just curious for 4Q whether there's any change in the way you are thinking about forecasting the internal business? And if you're handicapping these factors to a greater degree than prior quarters? And then more broadly speaking, do you think that 12% growth in billings marks a low water mark? Or could we see further slowdown from here? Thank you.

Gabriela, I believe there was several questions there. I want to make sure that I get them. I think the first question was, have we, do we feel like we have addressed the risk from the macro issues we were talking about? And I think the second piece in the second question was are we at the low water mark? Is that right?

Yes. That's right.

Fair enough. They are similar answers, I think. I think we are from a forecasting perspective we're very consistent on how we forecast. We want to address those issues and we believe we have taken those into account in our guidance and we certainly, we have certainly talked to the team and we have done a lot of research with them looking at it top down, bottom up, and you know trying to look at it as many ways as we can and making sure like we feel like we have addressed the issues. What we're really waiting to see I think is productivity improve. I think once we are hopeful that once our sales team has some time in place and when they mature. They are now more focused on the enterprise for instance, and I think once they are given the opportunity to be successful in their new accounts, when you think about all of the new people on board, then that's when we would expect ultimately to see things turn around, so to speak. I think until we have those signs, until we have actual signs, I think we want to make sure that we are taking the other factors into account with guidance.

That's helpful. Thank you.

Our next question comes from the line of Saket Kalia from Barclays. Your line is now open.

Just want to talk about the CP9 ASIC? Can you just talk about how much the appliance slate has been refreshed with CP9 and whether we think any of the pause this quarter maybe could have come from customers waiting for that refresh to happen? I guess more broadly, the question is -- any talk about the CP9 refresh affecting this quarter or the coming quarters would be helpful? Thanks.

This is Ken. I don't believe the CP9 has a big impact for the quarter. CP9 does have a huge improvement over CP8, and also we're just not in refresh from the high-end. Like when we introduce the 7000 series and we had a new model come out later this quarter, it is relatively new market and really the best performing, the most powerful machine in the industry address the big service provider and also call provider. But that is still in the early stage. We have not done anything in the other rings yet. That is to come later in the quarter. I think we always keep we now call it a security processor, whether it's a processor or chip processor -- and then every quarter we announce a couple of new products thus improving change from all of the 16 years is they smoothly introduce the product and lavish the latest technology, so if you have the CP9 still in the earliest ramp up stage and it does impact the heaviness.

Understood. Thank you.

Our next question comes from the line of Melissa Gorham with Morgan Stanley. Your line is now open.

I wanted to follow up on the commentary on the service provider business? I think last quarter it was relatively weak and I think the takeaway that it was maybe Company-specific versus something that was probably felt throughout the industry? Is that still the case? And I'm just wondering if you have additional color on what is driving the weakness? And then thinking about guidance, are you assuming that the softness continue?

This is Ken. I think the service provider --we still feel -- like I said, they're compared to like the last two years they have elevated purchase and now they are more strategic, trying to see what would be the long-term future direction. But also we see a quick ramp up that we call the cloud service provider starting to offer security in the cloud. They are also facing some similar challenge like the traditional service provider on how to secure the cloud and how to secure the pipe and how to secure the data. A lot of it is actually in the hybrid mode. It will impact the service provider and enterprise makes a decision, like which application will fit in the cloud, which application do you fit in there on the own datacenter. So I think that is where the service provider will plan in at the same time with the new cloud provider with some other enterprise making their decision about the future cloud trend. That I feel has some impact off the decision and also we do involve a lot of planning with them but I feel, compared to last year, this year some of the decisions take longer compared to one year ago.

Melissa we've taken into account -- you know we have obviously had detailed conversations with our carrier team and we believe we've properly taken it into account for Q4.

Also we have the best position in the care service provider competitor. We have a huge advantage on the portal side. On the service on the south model in the cloud, so we believe we are well positioned for the future growth once they finalize their decision or the strategic planning.

Great. Thanks.

Our next question comes from the line of Michael Turits of Raymond James. Your line is now open.

Obviously you have lower margins now with the pre-announcement and the guided into 4Q? Can you talk a little bit about your philosophy and your thought process with the margin expansion now, and delinearity towards getting to that 20%? How are you adjusting that and what can we begin to expect in terms of investments into next year?

Michael I think first start there are two answers to that. One, I think what question you're asking about is how do we get to 20%? Is that the first part of the question? And the second part is what are we thinking about in terms of investment?

Right. Obviously revenue is different than you are expecting? Are you adjusting in order to stay in that linear path?

Fair enough. Look, I mean okay, sorry. If you step back and you think what drives the 20%. I will start with that and then I will look at 60 and then talk a little bit about the investment. If you think about the leverage for operating margin obviously productivity is key. That's what we are banking on. We've made some investments. As the sales force matures and is hopefully successful, then that is a way to drive the install base. And obviously, margin expansion comes from expanding with an account versus landing, and it's more expensive. We also have some gross margin benefit which we have seen which is really due to the mix shift more towards the services line for all this reasons we talked about. And then there are generally some other efficiencies we could probably grab which could be spending initiatives. When we look at 2016 we've made adjustments to the team in August when we brought in XL ops to basically cover that off in terms of the dilution that would've been there. And we went to a more direct approach in sales with less carriers. And so we feel like we have make those adjustments. For Q4 we are probably not doing a lot, quite honestly, in North America. People, there's always some turnover and some people coming and going. So there's always some of that, and so without being too exact there may be a little bit of investment here and there and maybe some people leave you may not replace them. On balance I don't see a lot of investment there. Really, until we see things turn around. Internationally, we see pockets of growth and we continue to invest. We've reflected all of that in Q4 guidance. And going forward without guiding for next year, or getting into next year, hopefully what we would love to see is a productivity turnaround. Which should really be the tailwind you are looking for along with the mix shift of the services line to drive and expand the margin.

Our next question comes from Walter Pritchard with Citigroup. Your line is now open.

It's Jim on for Walter here. Based on what I am looking at here it would seem as though, it's like you should be seeing the sales force mature? And you just kind of answered Michael on the last question? When should we expect the sales force to actually mature to levels that you can start getting that leverage? Does it become a Q1, Q2 even back half of next year issue? Or it’s even as though that sales force should be more mature at this stage given the past hiring?

Fair question, Michael. What we're seeing is sales people who have been in their seat a couple of years are producing like somebody who has been in the seat for a year. And that's kind of the average. Two years ago they would ramp faster. But I think the market has changed and from what we are hearing from others we think the market has changed. And we talk about these macro shifts or these macro changes, where there is the consolidation theme, where customers are looking to consolidate on a platform or for other reasons to get end-to-end to get better pricing or whatever it is -- that's there. I think customers clearly are in a digestion phase, and we probably benefited that productivity-wise a few years ago in the past. And then they are also looking at NextGen architectures and pausing. Not necessarily going to the cloud yet. We don't see tons of that. We do see a mix shift of business showing up on the services line that probably -- it's new business that would've shown up on the product line in the past. And it shows up on the services line so it gets deferred. Which pressures margins early on because you're not getting that forward upfront revenue piece. And those are really the factors. So when we look forward we want to see signs of those -- you know, one, our success in growing the productivity as either customers begin back to what we believe are more aggressive buying behavior that would benefit us. Take into account also that we have remapped to more direct coverage. And it takes a while to develop those enterprise relationships. However, the consequence of that, you get deeper into that enterprise once you get in you have the opportunity to expand especially if they look to consolidate on a given vendor. And so we are hopeful that those are things that will help us. The other thing and -- within our control we also talked about enabling our sales team with more tools and things like solution guides and stuff like step selling. More lead gen and onboarding them more quickly with training and things like that we believe would help. But there are things that are out of our control which are the other themes we talked about, consolidation, digestion, NextGen architectures.

Our next question comes from the line of Brent Thill with UBS. Your line is now open.

Drew I think many of us are hearing about the shift from perimeter to internal segmentation and end point? I'm just curious if that is what you are seeing in your pipeline? And if so do you feel your sales reps are keeping pace there as it relates to the win rates against some of the best of breed vendors that are going after each of those spaces?

We do not believe our win rates have changed, Brent. We do not feel like we are losing deals. We just feel, what we're seeing is elongated sales cycles. The deals do not really go away if we look back to Q3 in Q2 we feel pretty good about it. And we've done some deep dives with the teams and they seem to be doing the right things in the right way to get there. But what you were talking about is we have not seen that impact our business. The one thing I would say to the extent that people look at NextGen architectures, and you look at a broader blend of technology than what you mentioned, that may be more impactful.

Also I do think in the internal ramp up quickly, but also we called the security fabric. We are into the internal segmentation you need to bring the whole infrastructure. So that's where we see the non-FortiGate part ramp up quicker than FortiGate. So that does all connect together through our security fabric but that is also some additional training to the sales team. That will take more knowledge and maybe a longer time for them to understand how to sell beyond the FortiGate that might combine this together as a total solution from ATP, e-mail, Wi-Fi access to the switch to the management. Even today, early today, we announced we [indiscernible] so that's additional service on top of the traditional 24x7 customer support. It is actually for the customer to do the health check and do the deployment and if they have some issue may be the customer is even not aware of so we can bring this ahead. That is the part where they have the training both for the sales and the engineer and also to the partner. That will also take a little more time. I think security fabric is the best solution for the industry and we have much broader solution than any other competitor but also take a little more time for the team to really catch up on this new solution.

The security fabric extends to the cloud. The products that Ken was going through, most of them are available virtual and physical. In the cloud business, as Drew said in his remarks, or Ken, it's actually one of the fastest, or was the fastest growing part of our business, the sales of the virtual offerings and the products that are available with AWS and Azure. There is a beneficial impact from the cloud. I think the non-beneficial impact could be something like Drew is saying is that it extends the sales cycles. As customers are planning their next-generation networks, perhaps shifting some to the cloud in the hybrid model and it does slow things down in the decision making process but we feel from a competitive standpoint we are very well positioned.

Our next question comes from the line of Gray Powell with Wells Fargo. Your line is now open,

You have increased prices a couple times on the subscription side since early 2015? Have those price increases fully worked their way into the install base? And as a follow-up, co you see potential for further price increases or the ability to introduce more expensive bundles?

Gray, Drew. I think there is probably a little bit left of the price increase coming but I would not expect much out of that going forward. You know we're not quite two years into it but certainly 18 months at least into it. So if you get the channel some time to absorb the price increases we're about 18 months into it and that is most of the way through. There is probably some opportunities on renewals. The one thing I would like to point out is we did announce the enterprise bundle which is a higher priced bundle in the past. We have seen some traction there which is a good sign. And so it would be more/less about the price increase and really, the story about enriching the bundles and charging more for the value-added through that, that includes the ATP solution and mobile security. And if you look at FortiCare 360 which we now this morning, that's another opportunity again where there is more functionality and value there that we are going to charge more for. But that is early stage and it would probably be more to follow on that. Would not expect a lot of out of it in the near term, but I think it is the right idea. And again part of our strategy is to really take advantage of the consolidation theme and this was one way to do it, and also protect our customers at the same time. Clearly if that is more valuable to them then that is something we feel can charge more for.

This is Ken. Actually we see price increases but also the new service we offer like an enterprise bond we offer the ATP service and also the cloud mobile security. So that is it two service the customer needs the most in an enterprise environment. We start to do service three or four months ago and rep are, we have 10% and we do believe customers see the huge value of ADP and the mobile security so it is a huge opportunity going forward.

Understood. That's very helpful. Thank you.

Our next question comes from the line of Jayson Noland with Robert W. Baird. Your line is now open.

I wanted to ask more on and S&P shift to the public cloud? Some of your peers have seen this part of the market accelerate to public cloud and it looks like your entry-level business was soft quarter on quarter by my math? Are you seeing this trend also? And can you talk a little bit more, Drew about how the economics differ in the public cloud sale versus an appliance sale? Thank you.

Let me take the first part and Drew can talk about the economics, Jayson. So if you look at the SMB, the business that would account for from the SMB standpoint would be business we're doing through the metered model with -- like in AWS and Azure. And as we mentioned before, that was one of the fastest growing parts of our business. It is doing well, its small. Its small for everybody right now, but it is -- we are seeing some very nice growth there. That would not be shown. You would not be able to see that other than the AWS business but yet I think it is doing as expected and doing well.

Yes and Jayson, I think for mix quarter to quarter it is hard for us to say that is a trend. It really just depends on how many distributed enterprise deals you did, perhaps. Or how much of that is going to be -- there is more in there and so as Michelle said we don't feel like we have been impaired on the SMB side. When you think about the economics, you know, obviously a lower price point you know up front, but as you extend the pay-as-you-go over time or the metered model over time, it surpasses the unit economics of a perpetual appliance or even a software perpetual license. So the breakeven point is somewhere north of the guidance. That takes time and it's a very high adhesion rate on that when you think about the fabric stretching end to end. Something the customers want and it is also higher-margin. When you think about our P&L, you translate that into our P&L, it is still such a small number. We do not feel like it's been that much of a drag on the top line, yet we don't really see that happening for the near-term. But what we think is, given about the way we are growing we think it is actually good news in terms of ultimately both growth and margin because again it is pay-as-you-go, its recurring model, its obviously higher-margin business that takes advantage of a given infrastructure so we think it is a good business to be in. It is something that is coming, probably SMB does come before enterprise obviously large enterprise. We haven't seen it yet but we feel like we could manage it into a model and be a tailwind ultimately to margin expansion and probably even market share.

Just to point on the technical side. Some of the SMB application moved to the cloud helps in some of the branch office solutions because when you move that data to the cloud you need a secure access to that data so you need a clean pipe. You also need a bigger, faster bandwidth to access the application in the cloud. So that is actually helping and you can see three years ago, we remember when most of the employed solution was based on accuracy data and now we are number two competitor. So we keep the increase in especially if it's a new introduction of the ISO three which has a 10 time performance functioning improvement so we feel like we have a stronger position in the SMB solution there.

Our next question comes from the line of Erik Suppiger with JMP Securities. Your line is now open.

This is John on for Erik. You have talked about bolstering the lead gen and branding to improve the business in North American enterprise? I was under the impression you have had kind of an elevated level of investment in that area over the last year or two? My question is what will you be doing differently to drive productivity and growth in North America? And also does the additional investment in lead gen and branding require incremental spending or is it just a shift in spending?

Sure, and John I will take the last question first. It is a reallocation in our mind. It's a reallocation. We are taking a very close look at where we feel we are getting the best return on our investment. And where we also feel we are trying to identify where we need to shift those investments. And trying to basically really get better productivity out of the dollars invested on the marketing side. When we think about it, and you think about productivity, there is a component of on boarding that we think is part of the answer. And the things there would be training and, you could be, we hire a lot of great people. I feel like we have a great team but they may be coming from another company and so there is a way that Fortinet sells and selling the fabric involves the complexity, especially given the things we talked about consolidation and NextGen architectures and digestion phase. It's a little different selling motion than two years ago. So we are really trying to arm people with how to sell into the enterprise, given those macro conditions and then also how to sell our products and sell the fabric. And again that takes a little longer. Along with that we want to do is make their job easier. We feel like our branding is much better than it was a year or two years ago. Most people know who we are now. We still get some of that but generally speaking, customers know who we are. They may know less about what exactly we do or how we can add value so we are pointing more marketing around specifically around that in the hope of driving improved lead generation to make it easier for our sales reps to sell and getting them to the right place in the Company to sell. Other things we are doing is just giving them more tools and solution guides and step-by-step competitive selling motions and making sure that those are appropriate given the conditions we talked about today.

Our next question comes from line of Shaul Eyal with Oppenheimer. Your line is now open.

Maybe on the heels of the final and most recent question, where do you stand on filling the position of Chief Marketing Officer?

This is Ken. We are still aggressively looking but at the same time we also like to say we're keeping in vast and improving the current marketing engine structure there and the digital marketing and digital engine. So we have like 40 or 50 people on board and we have a 150 leads and at the same time also on the poll outside from channel marketing so we're looking at the same time but building the structure ourselves right now.

Our next question comes from the line of Jonathan Ho with William Blair. Your line is now open.

I just wanted to go back to the consolidation of spending? Are you starting to see customers that you are dealing with do more bundled purchases across your product line? And sort of unifying and standardizing on the Fortinet fabric as opposed to the other way around where maybe you are trying to defend against some consolidation?

Jonathan it is Michelle. We are seeing that. As Ken talked about, the sales of non-FortiGate products significantly outgrew our overall business and we talked about one of the deals that he highlighted had a multitude of Fortinet products and obviously that was one of several deals that was done. So we are seeing that we do see the consolidation trend favoring Fortinet. We have a very broad offering with our fabric. It's what customers want. They are not buying everything today but they're actually buying more from us. And that is one of the things that we are getting in terms of helping productivity. To continue to train our sales force better to sell the broader Fortinet fabric because the trend is actually going on in the space with large enterprise customers we are having some success.

Jonathan I mentioned in my part of the call, my script part, about a fortune 500 travel company which is a hybrid cloud deal that included a combination of virtual FortiGate and FortiManager solutions along hardware appliances. And so really that illustrates the power of the fabric and it involved a cloud migration deal and so it has all of the above. And I think it illustrates the strategic approach customers are taking, again hybrid model -- both virtual and hardware and extending across a variety of products.

Also [indiscernible] just gave the product solution and that's the reason we launched the FortiCare 360. So that is proactively supporting and fund and identify the deployment issue and also gives them a better easy to manage some of the security solutions we have.

Thank you.

Our last question comes from the line of Imtiaz Koujalgi with Deutsche Bank. You line is now open.

I have a question about the guidance, so Drew if I look at the midpoint of the revenue guide and you assume a normal seasonality for the maintenance growth, I get park revenues going down or flat year over year and it's never happened before? Are you being extremely conservative or is it based on what you are seeing in your pipeline today?

Taz, look, obviously, we have taken an ounce or two of caution given the dependency on the products. When you think about the product revenue a lot of it is dependent upon the larger deals. Obviously, we had a challenging quarter in Q3. And for all the reasons we mentioned, the macro conditions and what we talked about productivity/execution. Brexit, LATAM, we want to make sure that we have a chance to see those things turn around in some way or some condition to see some blend of those before we go too far out on that front. And so we feel like we are reflecting that in our guidance. Clearly we would like to see larger deals, more larger deals. And those are some of the things. The only the other thing I would point out, Taz, is there is clearly a mix shift going on. And I just talked about a blended product where they are buying virtual products. There's some metered business, there's new business. When you think about product I think a lot of people think about that as being new. It's an indication of the future. Some of that new business is showing up on the services line. I think this is what we and others are seeing and it is several hundred basis points. At least 200 to 300 basis points of mix shift we're seeing into the services line that is showing up on the services line. So there's a few things we are trying to see normalize and you know I think we are reflecting that in the guidance.

This does conclude our Q&A session and I would like to turn the call back over to Michelle Spolver for closing remarks.

I know there were a few of you in the queue that didn't get to the questions. We do have another call, reminder, at 3.30 p.m. File feel free to call back then everybody and we will do the best to take the rest of your questions. Thank you very much.

Ladies and gentlemen thank you for participating in today's conference. This does conclude the program. You may all disconnect. Everyone have a wonderful day.