Fortinet Inc (FTNT) Q4 2019 Results - Earnings Call
Fortinet Inc (NASDAQ:FTNT) Q4 2019 Results Conference Call February 6, 2020 4:30 PM ET
Company Participants
Peter Salkowski - Vice President of Investor Relations
Ken Xie - Chairman and Chief Executive Officer
Keith Jensen - Chief Financial Officer
Conference Call Participants
Brian Essex - Goldman Sachs
Brad Zelnick - Credit Suisse
Melissa Franchi - Morgan Stanley
Shaul Eyal - Oppenheimer
Fatima Boolani - UBS
Sterline Auty - JP Morgan
Walter Prichard - Citi
Jonathan Ho - William Blair
Micheal Turtis - Raymond James
Rob Owens - Piper Sandler
Lewinski - D.A Davidson
Dan Ives - Wedbush Securities
Patrick Coleville - Arete Research
Imtiaz Koujalgi - Guggenheim
Nick Yako - Cowen and Company
Operator
Ladies and gentlemen, thank you for standing by, and welcome to the Fortinet Fourth Quarter 2019 Earnings Announcement. At this time, all participants lines are in a listen-only mode. After the speaker presentation, there will be a question-and-answer session. [Operator Instructions] Please be advised that today’s conference is being recorded. [Operator Instructions]
I would now like to hand the call over to your speaker, Mr. Peter Salkowski. Please go ahead.
Peter Salkowski
Thank you, Sherry. Good afternoon everyone this is Peter Salkowski, Vice President of Investor Relations at Fortinet. I’m pleased to welcome everyone to our call to discuss Fortinet’s financial results for the fourth quarter and full-year of 2019.
Speakers on today’s call are Ken Xie, Fortinet’s Founder, Chairman and CEO; and Keith Jensen, our Chief Financial Officer. This is a live call that will be available for replay via webcast on our Investor Relations website. Ken will begin our call today, providing a high-level perspective on our business. Keith will then review our financial and operating results, providing our guidance for the first quarter and full-year of 2020 before opening the call for questions.
During the Q&A session, we ask that you please keep your questions brief and limit yourself to one question and one follow-up to allow others to participate.
Before we begin, I would like to remind everyone that on today’s call, we will be making Forward-Looking Statements, and these forward-looking statements are subject to risks and uncertainties, which could cause actual results to differ materially from those projected. Please refer to our SEC filings, in particular the risk factors in our most recent Form 10-K and Form 10-Q for more information. All forward-looking statements reflect our opinions only as of the date of this presentation, and we undertake no obligation and specifically disclaim any obligation to update forward-looking statements.
Also, all references to financial metrics that we make on today’s call are non-GAAP, unless stated otherwise. Our GAAP results and GAAP to non-GAAP reconciliation is located in our earnings press release and in the presentation that accompanies today’s remarks, both of which are posted on the Investor Relations website. Lastly, all references to growth are on a year-over-year basis, unless noted otherwise.
I will now turn the call over to Ken.
Ken Xie
Thanks, Peter, and thank you to everyone for joining today’s call to review our fourth quarter and full-year 2019 results. We are pleased with our very strong fourth quarter performance. Billings increased 24% to $802 million driven by solid execution and growth across each of our markets EMEA and APAC.
Revenue increased 21% to $614 million with product revenue up 19% and service revenue up 23%. Non-GAAP operating margin was 27%, for 2019 billings increased 21% to $2.6 billion. Revenue was up 20% to $2.2 billion, and our non-GAAP operating your margin was 25%. These strong result was proven by our advanced FortiGate technology with SPU and our security, our integrated Security Fabric platform and hybrid multi-cloud offerings.
Fortinet was recently named one of the top three vendors in the 2019 Gartner Magic Quadrant for 1H infrastructure. Fortinet's security-driven networking approach SD-WAN offer customers the most comprehensive solution with security and [indiscernible] the networking capability integrating a single box.
Our unique approach [indiscernible] significant market share over the past 12 months with more than 21,000 companies using Fortinet's SD-WAN solution and 70% of a top-tier service provider offer our SD-WAN solution, we are now the leading SD-WAN vendors.
Today, we announced a release FortiGate 40F, the most affordable next generation firewall with secure SD-WAN. The 40F will include our new [indiscernible] security processor and 40F deliver security computer reaching speed to 23 times faster than use [indiscernible] which use general CPUs.
The traditional [indiscernible] base security has expanded across the entire infrastructure to the wide area network included in SD-WAN on 5G and to the local area networks, including the Wi-Fi and internal segmentation.
Fortinet's ability to offer secure [indiscernible] on top of performance with our SPU technology are clearly competitive advantages. Going forward, we are working hard to assure that Fortinet – growth engine will help us to grow faster than our competition and the market overall.
First, we continue to gain market share in mobile security, driven by our SPU competitive advantage. Our SPU technology enable us to add - security and network functionality including SD-WAN, while maintaining strong portfolio despite network traffic continue to increase.
The introduction of new SPU like [indiscernible] NP7 as well as the first FortiGate product build with NP7 to be market leader this month. It is expected to widen our competitive advantage. The second growth engine is our Security Fiber platform, including hybrid and multi-cloud deployment. Unlike competitive platform [indiscernible] integrate on acquired solution.
[indiscernible] was most developed internally after a broad automated and truly integrate security platform for end-to-end protection, making it easier for customer to consolidate for few security vendors.
Third our engineer focus the culture of continuous innovation strongly positions Fortinet for long-term growth and competitive advantage with at latest two times the technology pattern computation Fortinet IOT, IT, 5G, Hybrid cloud and edge solution are leading a transition to the latest generation of cyber security. I want to thank Fortinet team and our partners for their ongoing hard work and our customers for their support.
Now I would turn the call over to Keith for a closer look and our first quarter and full-year performance and to provide guidance with 2020.
Keith Jensen
Thank you, Ken. Let me first note that except for revenue, financial amounts are non-GAAP and growth rates are based on comparisons to the fourth quarter and full-year of 2018, unless otherwise stated.
The slide references I make refer to the presentation posted on our Investor Relations website. I would now like to provide a summary of our strong fourth quarter performance and follow up on certain metrics on the Analyst Day.
We believe the metrics we shared last November highlight our diversity by geography, customer size, industry segments and solutions as well as provide insights into our financial model.
Let's start our fourth quarter review with revenue. Total revenue of $614 million was up 21%, revenue growth was led by the fabric and cloud segments with over 30% growth followed by network security growth at 18% product revenue growth was 19% or 239 million benefiting from both legacy firewall use cases and consistent with Ken's SD-WAN commentary from continued adoption of our FortiGate based secure SD-WAN solution. Simply put our secure SD-WAN firewall use case combined with a single appliance security with application aware routing, that can lower NPLS and other costs.
The fourth quarter revenue growth of 19% was consistent with our strong third quarter performance. Even when faced with a more difficult year over year comparison. We believe our product revenue growth may be among the highest in this network security industry.
Moving to service revenue, our higher margin service revenue increased 23% to 376 million and represented 61% of total revenue, increasing 10 points in four years. FortiGuard security subscription revenue increased 24% to 205 million, FortiCare technical support and other service revenue increased 21% to 170 million.
Renewal rates remains consistent with prior periods and within the guidelines we provided at the Analyst Day. Deferred revenue at the beginning of the fourth quarter accounted for approximately 90% of service revenue. Revenue growth on a geographic basis saw the America's up 23%, APAC up 22%, and EMEA up 19%.
Before continuing with our fourth quarter results, I would like to highlight our revenue performance for the year. Total revenue for the full-year of grew, 20% to $2.2 billion. Product revenue grew 17%, service revenue grew 21% and represented 63% of total revenue.
Returning to the fourth quarter with a focus on billings. Total billings increased 24% to 802 million. Network security product and service billings increased 20% and accounted for 73% of total billings. Illustrating the continued traction with our fabric platform and cloud strategies, non-network security billings increased 35%.
In Europe, we saw Germany performed better-than-planned, while in the UK billings declined. The UK decline appears related to Brexit distractions and we expect UK billings growth will return to positive territory in the current quarter.
Looking at billings by vertical. Service providers and MSSPs accounted for 18% of total nillings, and we experienced outpaced growth from government, financial services, retail and education. As a follow-up to the Analyst Day, - top five verticals again accounted for 65% of total billings. At year-end, total deferred revenue increased 27% to $2.1 billion and short-term deferred revenue increased 22% to $1.2 billion.
Looking now at deal sizes and illustrating our continued expansion in the enterprise market. Deals over $1 million increased 36% to 64 deals. Secure SD-WAN was a leading contributor to the increase in the number of deals in excess of $1 million accounting for 10 deals in the quarter, up from four deals last year.
And with a reference to our diversification, we have now completed 11 quarters in a row without a single transaction representing over 2% of quarterly billings. The number of deals over $250,000, increased 29% to 469 and the number of deals over 500K increased 53% to 197.
In the fourth quarter, our average contract term increased one month to 26 months. As we noted at the Analyst Day, secure SD-WAN transactions included greater mix of enterprise customers and somewhat longer contract terms.
Moving back to the income statement. In the fourth quarter, gross margin improved 230 basis points to 78%. Product gross margin improved 400 basis points to 61.9%. As we saw in the third quarter, product gross margin benefited from gains in average selling price as well as lower direct unit costs and indirect cost.
We are pleased with the product gross margin improvement we have achieved in each of the last two quarters. Services gross margin increased 90 basis points to 88.2%. Operating margin for the fourth quarter increased 110 basis points to 26.8%. The improvement in gross margin was partially offset by an increase in the pace of hiring, mostly in sales and marketing, lower sales attrition and spending associated with recent M&A activity.
For the full-year, gross margin was 77.5%, up 150 basis points from 2018, benefiting from a 190 basis point improvement in product gross margin. And for the full-year the operating margin was 24.5%, up 220 basis points from 2018. Total headcount at end of the year at 7,082, an increase of 21% from the end of 2018. However, the two fourth quarter acquisitions increased headcount by 135. Excluding these two acquisitions, headcount would have increased 19%.
Given the strong operating income performance, net income for the fourth quarter was a $132 million or $0.76 per diluted share. Net income for the full-year was $432 million, an increase of 35% resulting in earnings per diluted share for $2.47.
On a GAAP basis we reported full-year net income of $327 million or $1.87 per diluted share. This represents our 11th consecutive year of GAAP profitability, a milestone we have been able to achieve every year since becoming a publicly traded company in 2009.
Moving to the statement and cash flow, summarized on Slides 10, 11 and 12. Adjusted free cash flow for 2019 increased 28% to 776 million. Capital expenditures for the fourth quarter were $47 million including $36 million on real estate spending.
For 2020 capital expenditures are expected to be between $210 million to $240 million which includes spending on the campus expansion. We expect first quarter total capital expenditures to between $25 million and $35 million again including spending on the campus expansion.
In the fourth quarter, we purchased approximately 303,000 shares of our common stock for a total cost of $23 million. For the full-year, we repurchased 1.9 million shares for a total cost of 141 million. At the end of the fourth quarter the remaining share repurchase authorization is 1.6 billion with the plan set to expire at the end of February, 2021.
Before wrapping up with guidance, I would like to offer information on two additional areas. Our four acquisitions and also SD-WAN. First on the MNA side, we completed two technology and talent tucking in acquisitions in late October and December.
With a combined contribution to fourth quarter revenue significantly less than 1% these acquisitions pull down fourth quarter operating margin by approximately 1.5 or a percentage point. We expect the impact from these acquisitions on first quarter and full-year 2020 operating margins to be roughly a 100 basis point headwind.
Second, our secure SD-WAN offering continues to be a point of differentiation for that. In the fourth quarter secure SD-WAN billings represented high single-digits of total billings. In 2019 for the full-year secure SD-WAN added bout seven points to product revenue growth and represented mid to high single-digits of total billings.
On a full-year basis there were no significant changes to the year-to-date third quarter metrics for secure SD-WAN that we provided at the Analyst Day. Service contract continue to attach to the FortiGate with the rate consistent with other FortiGate use cases. And finally, new logos continue to account for approximately 50% of secure SD-WAN billings.
Next, I would like to review our outlook for the first quarter and full-year of 2020 summarize on Slide 13, which is subject to the disclaimers regarding forward looking information that Peter provided at the beginning of the call.
For the first quarter, we expect billings in the range of 635 million to 655 million. Revenue in the range of 555 million to 565 million, non-GAAP gross margin from 77.5% to 78.5%, non-GAAP operating margin of 19% to 20%. Non-GAAP earnings per share of $0.15 to $0.52 which assumes the share count of between 175 million and 177 million. We expect a non-GAAP tax rate of 24%.
As I being to provide 2020 guidance, I would like to remind everyone of a financial model expectations for the next three years that was provided at the November Analyst Day. For the period from 2020 to the end of 2022, we expect organic billings and revenue growth to be at least 15% for each of the next three years and non-GAAP operating margin to average at least 25% during this three year period.
For 2020, we expect billings in a range of 3,025 million to 3,075 million, revenue in a range of 2,525 million to 2,555 million. Total service revenue in a range of $1,635 million to $1,655 million. Non-GAAP gross margin of 77.5% to 78.5%. Non-GAAP operating margin of 23.5% to 24.5%.
While we estimate the recent acquisitions will be a 100 basis points year-to-year headwind to our 2020 operating margin included in the numbers of above, we believe our operating margin over the next three years will average at least 25%. Non-GAAP earnings per share of $2.70 to $2.73, which assumes a share count of between 180 and one 182 million. We expect our non-GAAP tax rates to be 24%. We expect cash taxes to be approximately $40 million.
Along with Ken, I would like to welcome the [CyberSponse] (Ph) and again the entire team to Fortinet and thank our partners our customers and the Fortinet team for all their support and hard work. With that, I will hand the back over to Peter.
Peter Salkowski
Thank you very much Keith. Operator, we are ready to open up for Q&A please.
Question-and-Answer Session
Operator
Thank you. [Operator Instructions]. Our first question comes from the line of Brian Essex with Goldman Sachs. Your line is now open.
Brian Essex
Hi, good afternoon. Thank you for taking the question and congratulations on some nice results. I was wondering, Keith if maybe you could unpack the guidance a little bit. Coming in particularly on the growth side of the equation, several hundred basis points over a your kind of at least 15% guide on the Analyst Day. Where does the confidence there come from? And what are some of the levers that could, I guess give us some comfort that there is appropriate level of conservatism in that number?
Keith Jensen
Yes, I think when you look at a longer-term model, you are probably looking more at Gardner growth rates in terms of what you expect to see from SD-WAN, what you expect to see the Network Firewall. And what you expect to see in the fabric. And I think the guidance is certainly within those ranges, when you factor in our historical ability to outgrow the market.
I think if you get, as you pull that in, particularly to say the first quarter, even the current year, it is much more based upon the pipeline, and when we look at the pipeline and the opportunities that we see in the pipeline, it clearly supports the guidance that we have just provided.
Ken Xie
Also, we do increase sales capacity with additional - sales and marketing, which of course 20% for total headcount increase, will definitely help you drive the additional growth.
Brian Essex
Got it. That is helpful. And maybe if I could follow up with a quick one on current results for the quarter. Product revenue, you know, nicely strong in the high teens and services revenue as well during the quarter where maybe some of your peers found a little more challenging to put up positive product revenue growth, at the very least know. How much did, I guess SD-WAN and fabric contribute to each of those segments. And how might you view the overall spending environment for a core firewall considering the results that you had. I did hear you comment on high single digit, SD-WAN contribution, but if maybe you could play in a bigger picture of other contributing factors to those line items in the spending environment overall would be really helpful.
Ken Xie
Yes this is Ken for the [indiscernible] security, we believe we are getting a lot of market share because the product architecture with our own pace, probably [indiscernible] SPU is a huge concrete in power and keep adding whether security function or the networking function that SD-WAN.
Like even the product we announced today, like that is from 3x to 23x more powerful than other competitors industry average. So this will keeping, gaining in market share. And also [indiscernible] by market last year is about 1.5 billion and make 50% year-over-year in the next few years.
So we are now the leading vendor, as you - with the most of the costumer and also most of the service provider also studied [indiscernible] SD-WAN solution [indiscernible] we are also keeping gaining share in that space. So that also would helping us. And the fabric you can see almost double the network security growth, because all fabric it is mostly internal developed and well integrated.
That is more easy tool like a optional cross-sale, [indiscernible] some product ID and because all the other part of fabric kind of working together quite well, so that is where customers see the benefit of our consolidation. So we see that is also a growth drive.
There is two other new technology, we also pioneer but that probably more long-term maybe a few more years to see more [indiscernible] we also lead in some of the technology changing in the space.
Brian Essex
Fantastic. Thank you very much.
Ken Xie
Thank you.
Operator
Thank you. Our question comes from the line of Brad Zelnick with Credit Suisse. Your line is now open.
Brad Zelnick
Fantastic and I will echo my congratulations. What a real strong finish to 2019 and an impressive guidance as well. Ken, if I can ask you a question, and I look to competing SD-WAN solutions out in the market, I think there are some out there that take a different architectural approach in delivering it mainly as a cloud service. Aside from customer preference, can you maybe speak to the architectural trade off of centering the functionality in the cloud versus delivering it as you do?
Ken Xie
I think by meeting some applications with the cloud, actually helping like more deployment in SD-WAN and at the same time even within the cloud, there is a few research actually whether [indiscernible] come from like academia and like a CMU that the cloud actually increases security risks and that is why even within the cloud you also need to secure the cloud itself. So that is also helping like, we call the hyper scale, some underpin approach to get insight network and that is probably beyond that traditional, I mean the SD-WAN side.
We kind of do work with a lot service provider, cloud provider and make SD-WAN part of the total offering. And then we also understand sometimes they have their own business model most supporting each other, instead of more competing with each other. So that is kind of the ecosystem setting working quite well for us.
Brad Zelnick
Thank you that is very helpful Ken and Keith if I could just follow-up the quick one for you. DSOs seems to be running a little bit hot. Can you comment at all on linearity? I mean at the same time you have obviously guided to you know a very nice Q1 and full-year next year. But any color on the jump would be helpful. Thank you.
Keith Jensen
Yes. I think math of DSO, we picked up about a days from the acquisitions and that is pretty much puts us back in line with what you would expect normally. I would offer my experience in high tech in the Christmas holiday season is always very busy - unusual.
Brad Zelnick
Fair enough. Thank you so much.
Keith Jensen
Thanks Brad.
Operator
Thank you. Our next question comes from the line of Melissa Franchi with Morgan Stanley. Your line is now open.
Melissa Franchi
Thank you for taking my questions and congrats on a solid quarter. Ken, it looks like you are seeing good growth in large deals and multimillion dollar deals. And I know that you said that SD-WAN is a leading contributor to strength there, but I'm just wondering if you could provide more color on what those deals look like. Is it your existing customers that are refreshing at the branch or are you displacing some competitors solutions that are coming - and you are coming in because of the SD-WAN capability.
Ken Xie
So half of the SD-WAN customers are new customers, especially comes from a lot of enterprise. And that also enable us to carry into the traditional enterprise network security space. Although, the internal, I can say the traditional parameters based security now need to be spent to the one side like SD-WAN 5G and also to internal like whether the internal segmentation switching all the internal Wi-Fi. So that is where we see that.
Probably internal even bigger market compared to SD-WAN side. So, we see a huge opportunity, especially we introduced the new NP7. So the first part I leveraged NP7, which is about five times faster than the previous chip NP6 will help us to get insight in networks in a more high speed environment within the cloud. So, that also additional growth.
So, I do see the SD-WAN go to the WAN side and also go to the internal network side help us to expand a lot of new market inside enterprise and also in a lot of new customers for us.
Melissa Franchi
Okay. Very helpful. And then I have a follow-up for Keith. Keith you mention that ASPs were increasing in your commentary on gross margins? Can you just maybe comment on what is driving that ASP increases? Is that just a mix shift dynamic or did you actually raised prices on appliances?
Keith Jensen
Yes. I think what I'm trying to do is parse out the fact that in the benefit to gross margin, there was really three pieces to it, indirect, which I would attribute to economies of scale that we are seeing. We have a large warehouse facility that we acquired a number of years ago and I think that is a fairly “permanent benefit” from an indirect side.
On the direct side, I think the operations team does a very good job of each quarter working down the average direct unit cost, and then the third component was ASP. And I kind of broaden that conversation, if you will talking - from the last quarter, I attribute it to discounting.
And the reason for that is I would put discounting as a component of ASP. But, I also want to give some credit to the ability of the company, if you will to maintain the somewhat normal price list changes you have from time-to-time and not giving those back and discounting.
Ken Xie
The other economy of scale workings really the ASIC chip, right. So, we are the number one unit shipment probably more than the number two, number three, number four combined. It really help us in kind of lowered average cost of per ASIC chip which give us huge computing power over that generic CPU to combine the usage, so that is also helping driving the costs lower.
Melissa Franchi
Very helpful. Thank you.
Operator
Thank you. Our next question comes from the line of Shaul Eyal with Oppenheimer. Your line is now open.
Shaul Eyal
Thank you. Good afternoon gentlemen. Congrats on the stock performing. Keith or Ken Germany and the UK or maybe we should call it France and London tale of two countries, tale of two cities. Talk to us a little bit about what has been driving the strength in Germany and why do you expect the UK to bounce back in the first quarter?
Keith Jensen
Yes. I think the - sorry Ken for jumping in. I think in Germany I think it is just been a balanced growth throughout the quarter. I think we came into the quarter with perhaps some concerns given the economy down in Germany. So the diversification that we see within the country, I think paid off for us.
I think in the UK, to answer to the question very specifically when I look at the pipeline in Q1 versus what we saw in Q4, I feel very comfortable to comment about it returning to positive growth in the quarter.
Shaul Eyal
Fair enough and maybe one of the few lines that [indiscernible] APAC what is driving that and do you see that contributions or growth as sustainable within that region?
Ken Xie
We have had a pretty good fourth quarter and also we are starting to speed up some hiring there which is a little bit behind the early last year, which is kind of helping drive the future growth.
Shaul Eyal
Well done. Thank you.
Keith Jensen
Thank you.
Operator
Our next question comes from the line of the Fatima Boolani with UBS. Your line is now open.
Fatima Boolani
Good afternoon. Thank you for taking the questions. Ken, I will start with you. Just with regards to SD-WAN tremendous momentum there. I wanted to understand just from a strategy perspective, how you are pitching the SD-WAN value proposition to your Telco and service provider and carrier partners, because to some extent the secure SD-WAN proposition is counter to some of the other areas of Telco’s businesses like the NPLS stream. So I wanted to better understand what your strategy is with Telco and then I have a follow-up for Keith if I may.
Ken Xie
Yes it is no more total cost ownership. Especially we have a one box solution compared to some other network vendor whatever, you need to have a two, three box once for SD-WAN, one for security, one for [indiscernible] and so we have all this integrated single box and also because the huge computing power come from our SPU security process unit, so we can easily outperform and add additional function, combine all the security and network function together and easily like three to 30 times faster than other like a single SD-WAN function box or security box.
So that the advantage we have in the technology investment for ASIC chip give us huge computing power not just for the SD-WAN function, but also additional security function, additional network function we keeping adding there. So that is where the service provider enterprise should see the benefit, because for them whether using the box to touch whether service based revenue all kind of helped in lower enterprise total cost.
So that is where we see over 70% top tier service provider all for our SD-WAN solution. So that is where we become a leading vendor. We had the most customer base study of SD-WAN [indiscernible] solid costumer companies study using our SD-WAN which combine SD-WAN security together and also is very interesting.
So the service we offer with SD-WAN actually is the highest level service we have. So, we do have like a UTM service, enterprise service and then that we call the 360 service, which like, including all the UTM enterprise and pass all the provisional service include SD-WAN provisioning and management service.
So that is where SD-WAN definitely helping to drive the additional service, additional security into a lot of new enterprise customer, which become half of the SD-WAN deals come from a new customer which never bought other products before.
Keith Jensen
Yes. And I think, just to follow-up on Ken's comment. About the 70% of the SD-WAN -. I think we probably saw specifically in the first half of 2019 was a little bit of hesitation from the carrier and the service providers maybe have a little bit to their MPLS revenue streams, but we have certainly seen a shift in that thinking I would say over the last three or four months.
Fatima Boolani
That is super helpful. And Keith, just for you, you are very specific about the step up in sales hiring into the higher pace of sales hiring. I'm wondering if you can put a finer point on where these additional sales resources and increased sales capacity is going to be concentrated, whether from the vertical or geographical or even use-case perspective? I would appreciate that color. Thank you.
Keith Jensen
Yes. I think, I would probably respond to that question is the way we look at it in terms of adding sales capacity, and there is probably two key criteria that Ken and I talk about. One is we want to see somebody sales leader who has demonstrated performance, so when you give them the resources that they are going to be able to execute, whether then two, that they want that additional responsibility. Now like luckily in a very good position where that that crosses geographic lines and crosses vertical. But I think that is more of the playbook that we are after right now.
Fatima Boolani
Thank you.
Operator
Thank you. Our next question comes from the line of Sterline Auty with JP Morgan. Your line is now open.
Sterline Auty
Yes. Thanks. Hi guys. Ken, wanted to start out with, as we think about the SD-WAN products roadmap, especially here in 2020, what are some of the key elements that you would expect to introduce this year that had been missing in the solution thus far?
Ken Xie
Definitely we are working closely with a service providers, which kind of more dominant in that space and offer lot of managed SD-WAN service and also a lot of channel partners working with us, [indiscernible] leader so they see the benefit of SD-WAN solution compared to their traditional solution.
The other thing we probably, maybe overdose, or maybe we did had right now is really, NP7 we kind of talk about in Analyst Day and then later this month we'll introduce the first product of NP7 accelerate - which also would change a landscape. This is more like a product starting inside the network.
So, that is where the internal segmentation, the hyper scale, some other product could be even bigger market in wide area network which is SD-WAN leading in the last few years. So, that is where there is a few driver keeping helping us. Like the [indiscernible] SD-WAN in the one side - on chip and then NP7 will help you on the local area network in the high speed environment. So that is where we staring to see the traditional parameter based network security needs to expand into the one side and also the land side.
Sterline Auty
Got it. And then Keith, I apologize, I was bouncing between calls but apologize if you had covered it, but I want to better understand the operating margin guidance here for 2020 and in particular, how much of that impact is coming from being acquisition versus the increased hiring and specifically, you know, are you at the end of this maybe increased investment phase and how does that margin outlook for 2020 fit within your longer term margin guide?
Keith Jensen
Yes. Very good question. Let me try to cover off, in the prepared remarks that the reminder, including the fact that our comment before was that from 2020 to 2022 we expect to average at least 25% operating margin during that three year period of time, first and foremost, that has not changed.
The other data point to keep in mind in the commentary was that the M&A the kind of hit in the tail half of the fourth quarter, the drag in operating margin in the fourth quarter was about a 0.5 basis points. And the drag for the next year when we have full quarter operations, it is going to be about a one point of drag. And so one way of looking at it is taking our operating margins to midpoint and then adding that point back into it.
Sterline Auty
Got it. Thank you.
Operator
Thank you. Our next question comes from the line of Walter Prichard with Citi. Your line is now open.
Walter Prichard
Thanks. Question on the subscription side and specifically pretty good performance on the FortiGuard there. Can you help us understand components of that as you have seen that business accelerate this year, what is been the driver of that trend?
Keith Jensen
Yes. FortiGuard, I kind of go back to those, some commentary from the Analyst Day. About 85% of FortiGuard are bundle, security bundles. You can add to that some standalone security services if you will. You are also going to get when you are trying to model that you can also get a lag effect of when you see high product sale. Say it is higher in 2018 than they were in 2017 those higher product sales in 2018 are going to attached service contract which become revenue in 2019. So you are going to get the lift in 2019 from the increase in product sales in 2018.
Walter Prichard
And then just a quick one on acquired revenue, how should we think about any contribution, you said a small contribution in Q4, any contributions from the two acquisitions in the 2020 number?
Keith Jensen
Yes, we have just rolled in it as a total and I think the comment I gave was it was far less than 1% in the fourth quarter. I don't really see that changing for the balance of that I have visibility to in 2020?
Walter Prichard
Okay. Thank you.
Operator
Our next question comes from the line of Jonathan Ho with William Blair. Your line is now open.
William Blair
Congratulations on the strong quarter. Just one for me, I just wanted to get your sense of what is happening in the cloud opportunity. You guys mentioned hybrid cloud and you know, sort of the multi cloud security opportunity. Just want to get a sense for what trends are seeing particularly for 2020. Thank you.
Ken Xie
We do see cloud as a part of a fiber offering. So we gave the customer flexibility, whether they want to be put on [indiscernible] choosing different cloud provider. We offered the same like user interface, same - kind of a solution for them and also we are working with cloud provider service provider well and trying to expanding on that area. So that is - drive for us.
We do believe both cloud and edge need to be working together, certain thing good for cloud, certain thing good for edge, so that is where the whole solution instead of on focus headline solution, so that is where the - fabric on the cloud, the edge other I mentioned like a IoT, OT and the 5G all could be kind of working together to make it more secure.
Peter Salkowski
Operator, next question please.
Operator
Thank you. Our next question comes from Micheal Turtis with Raymond James. Your line is now open.
Michael Turtis
Hey, guys. Good afternoon and good evening, great quarter. First for Ken, you announced the Fortinet Secure SD-WAN on equinox. So, SD-WAN you said as a full service. But, what are your offerings and what is your strategy on a full cloud-based security offering that you would think of that would be analogous to as the scale offering, either for local breakout and or for zero trust network access.
Ken Xie
I think these scale don't have the SD-WAN and sometimes we also partner together and on the other side like a lot of service provider [Acronis] (Ph) they do have quite a broad customer base, enterprise customer service provider and leverage their infrastructure. So SD-WAN definitely is a new technology solution like improving the surveys, lower the cost and that is where those service provider, the enterprise customer all like that solution.
So that is where we kind of approached from both once from end costumer angle and with marketing force with BDR resource and the other one the service provider [indiscernible] helping their customer to improving the better service lower total cost of ownership. So, that is where we see what can the service providers [indiscernible] important ecosystem for us.
Michael Turtis
And then for Keith on cash flow. This year, cash flow grew less than net income this year in the 20s versus in the 30s. How should we think about it going into next year is that is just timing that reverses, should we think about cash flow from ops growing in line with net income or even next year?
Keith Jensen
So, I think if you are looking at cash flow from operations, then you are excluding the real estate, correct. You are not talking about free cash flow, Michael.
Michael Turtis
Not talking about free cash flow. Just cash flow.
Keith Jensen
Yes. I don't think there is nothing different in terms of modeling it other than just maybe when the quarter ended and how payables got paid and how receivables got collected and so you premise that you know, basically to put words in your mouth, don't look anymore quarter. We will look at it over time. You are right.
Michael Turtis
Right. So in other words, in-line with net income or EBITDA growth this year, is a good guide?
Keith Jensen
Yes.
Michael Turtis
Good. Great. Thanks very much.
Operator
Thank you. Our next question Rob Owens with Piper Sandler. Your line is now open.
Rob Owens
Great, and thanks for taking my question. I want to drill down a little bit into linearity with regard to 2020 and I know in 2019 we saw a very strong back half out of you guys and obviously some of the new, the new products nasty win helps there, but you are also making that push up relative to enterprise. So, are we seeing the business become a little bit more enterprise back end weighted? Does that play out in 2020, and what should our initial linearity thoughts be? Thanks.
Keith Jensen
It is a good question. We spent some time at time actually recently looking at it. And I think, if you start looking at 2018 so in the area by quarter, that is probably a pretty good idea of what we think, I'm sorry, 2019 linearity. We have got a pretty good idea of what 2020 will look like at least in terms of how we are modeling internally.
So you are probably looking book ending the year we are starting off at 21%, and then in the year in the fourth quarter with maybe 29% to 30% kind of a model. And in between, you know where a model where Q2 and Q3 tend to be very close together. So you are probably around a 24%, 25% number for both of those.
Ken Xie
We also improve the hiring in the second half of 2019, which we think will be contributing for the 2020 growth. So that is where - like a Q3, Q4 definitely will - starting to ramp up to contribute in this year 2020.
Rob Owens
Great. And then if we look at the large deal metrics, particularly the largest of deals, are these you guys pushing up market into data center situations that are massive or more branch network types of situations. Could you unpack that a little bit for me? Thanks.
Ken Xie
Its more enterprise. That is because a lot of enterprise see the benefit whether SD-WAN - infrastructure security, your are moving more product in a fabric, fabric also helping to make the deal larger. So that is where with most sales more - able to sale marginal products and also the SD-WAN starting to more like enterprise so it definitely help increase the deal size.
Rob Owens
Great. Thank you.
Operator
Our next question comes from the line of Andrew Lewinski with D.A Davidson. Your line is now open.
Andrew Lewinski
Great. Thank you. And congrats on a great quarter. So I also want to ask you a question on your large deal growth. You know, we saw the deals greater than 500,000 in those greater than a million, with impressive growth again this quarter, yet your high end appliance revenue lagged, the small and mid range of Plains growth. So I was just wondering is if you could just provide any more color as to, you know, why are customers spending more up front with you since it doesn't look like they are buying, you know, simply just buying larger appliances.
Ken Xie
The new point to come in, like I said it takes us almost four or five years to develop NP7, so that is where we finally released and the first part of our [indiscernible] later this month. So that will have a huge advantage compared to some of those part. So it will help.
Keith Jensen
Andrew its Keith a good follow up question to Rob and to expand on the Ken’s comment. I think when you look at where the large deals are coming from, I would probably say there is really three sources for those. One of the SD-WAN that we talked about, two was the large distributed enterprise that you are referring to. And then the third is yes, how do we success inside the data center and displacing commerce. And I think each of those are contributing to the growth that we are seeing in million dollar deals.
Andrew Lewinski
Great. Thank you. And then as just a clarification regarding your gross margin, I know you mentioned, the economies of scale, as contributing to that, but the guidance for 2020 is a significant expansion from 2019 and I thought that new appliances typically carry a lower gross margin at least initially. And so, you know, given the new appliances you have talked about that are coming out later this month, I was wondering if you could provide any more color as to what might be driving your gross margin higher in 2020 and offsetting that perhaps initial headwinds you normally face with a new appliance.
Keith Jensen
Yes. And keep in mind, we probably have 70 or 80 different firewalls, on the price list at any one model at any one point in time. And then also add to that, introducing a new product doesn't necessarily mean that is going to have a significant revenue impact to a given point or to a given quarter.
I think, I wouldn't overplay the new products, having an impact on gross margin, unless we are doing a lot of them all at once and they are coming online. I think that, if you go back to what is actually in the, if you are simply talking about product gross margin and I think you were in your commentary, I made reference to three components.
One is I think the indirect benefit is here to stay, given the economies of scale. I do believe that the direct benefit is can be rackets to over basic advantage will continue to manifest itself into our pricing and into our billings. And then thirdly, I now have two quarters in a row where, what do you want to call it?
ASP increases or holding line of discounting. I'm not going to commit to say that, that is going to be forever, but I think those are the components that we are looking at in terms of our modeling product gross margin going forward.
Lastly, if looking at total gross margin, it is really a mixed shift as well. Whereas at the moment, we are probably modeling a little more services with higher margin than we are with products at this point in time.
Ken Xie
Yes. Also with the two new SPU [indiscernible] chip for the NP7 we have a huge competing power enhancement on a 40K, it also enable us, we will keep adding new out functions, which also drive the service. Helping like nice discount and additional [indiscernible] value added with the same cost? So, that is also will help to improve our margin.
Andrew Lewinski
That is great. Thanks for the color.
Operator
Thank you. Our next question comes from the line of Dan Ives with Wedbush Securities. Your line is now open.
Dan Ives
Yes, thanks. So, my question is specifically on the government vertical. I mean, could you just maybe talk about what is going on there? Obviously there is a lot of transformation going on in deals across, especially on the federal side where you guys obviously play well. So maybe just talk about that in terms of the composition of deals activity and just is anything changing on federal?
Keith Jensen
Yes. After reading my email, I saw something this morning going to our sales people talking about very exciting times are coming in the U.S. Fed. But I think really what you are seeing in our model right now is really a diversity in our government business, which includes some benefit from the U.S. Fed but also state, local and international governments.
Dan Ives
Got it. And Ken, could you just hit on 5G? I mean I know you, you have talked about before, but just how you are viewing that over the next 12-months to 18-months and where is in that opportunity? Thanks.
Ken Xie
Which one?
Keith Jensen
5G.
Ken Xie
Oh, 5G. I think it is too a little bit early, certain vertical, maybe ahead of the consumer, but working closely with a service provider by the [ACA] (Ph). Obviously you need a couple years out to see material impact.
Dan Ives
Thanks.
Ken Xie
Thank you.
Operator
Thank you. Our next question comes from the line of Patrick Coleville with Arete Research. Your line is now open.
Patrick Coleville
Thank you for taking my question and congrats on the seriously impressive quarter, and the next year's outlook. Can I ask a financial question on the free cash flows to start with. How much you are spending in 2020 for the new campus?
Keith Jensen
Yes. The real estate spending probably around between $150 million and $160 million all-in next year.
Patrick Coleville
Got it. Okay. very clear. And then Ken, can I ask you about, ransomware. I do a lot of work CISOs and CIOs and in my conversations, that is probably the number one threat facing right now. So I would love to understand from full to net perspective, how a tool that may be driving conversations with you guys and your customers.
Ken Xie
That is very important topic because the majority are packed today, now come from inside. So that is where internal security, internal segmentation and at the same time combined with some other like end point security like the company we just acquired [indiscernible] some under it is ready, I think are more and more important.
And then also the new NP7 definitely help driving that direction inside a company network and wider segment, different department or server or data source there and even per person. So that is what helping paddle for these ransom ware attacks.
Patrick Coleville
Great thank you very much.
Ken Xie
Thank you.
Operator
Our next question comes from the line of Imtiaz Koujalgi with Guggenheim. Your line is now open.
Imtiaz Koujalgi
Hey guys, thanks for taking my question. I had a question on the equinox partnership. Can you just talk little about the go-to-market there, would like to [indiscernible] work in that case, would it be sale of product or will that be - as a service offering.
Ken Xie
Probably both staring from go-to-market together and then we also look out some other - for partnership including student production, sort of offering is a starting of good partnership.
Keith Jensen
Yes. And I think it is probably just a little bit early you talk about rev rec. First of it start, it’s from the last one for our. So we will try to.
Imtiaz Koujalgi
And then just a clarification on the guide. So given that your product revenues were basically they grew at the same rate in 2018 and 2019. We assume that the service revenue there is no decline in the service revenue growth in 2020, you should basically have the same service earning growth in 2020 that you had in 2019.
Keith Jensen
I think we actually included in the guidance service revenue for the year, so I think that will probably give you a pretty good visibility to it in the prepared comments.
Imtiaz Koujalgi
Okay. thank you.
Operator
Our next question comes from the line of [indiscernible]. Your line is now open.
Unidentified Analyst
Hi guys. Congratulations on a great quarter. I noticed that obviously the billings number was much higher than you thought and I'm just wondering, you know, what was the component behind that?
Keith Jensen
I think we saw a very good performance many, many [GL] (Ph), account base, the U.S. is being a very, very strong GL. We also did very well in our emerging markets in the quarter. It was strong and I gave you the revenue numbers. This is a pretty good indicator but I think really if I would call out in terms of where the strength was in the quarter, I was very pleased with the U.S. in our emerging markets.
Unidentified Analyst
Congratulations.
Keith Jensen
And I should have, pardon me? I didn't mention on the Tam author who did a great job. Again, I'm going to get in trouble and it did a very good job.
Operator
Thank you. Our next question comes from the line of Nick Yako with Cowen. Your line is now open.
Nick Yako
Great. Thanks for just my questions. I wanted to ask about fabric and just wondering if you can provide any color around the percent of FortiGate customers that have deployed a fabric product and then maybe how that is trended over the past few years.
Keith Jensen
I think there is - if I understand the question correctly. I think there is a very high correlation between fabric customers and FortiGate products. It is fairly unusual for us to sell a fabric product to somebody who is not a FortiGate products customer.
Nick Yako
Right. Okay. And helpful color around the SD-WAN contribution in 2019, and any color on what that contribution was in 2018.
Keith Jensen
Very, very small. I don't - low single digits at best, probably.
Nick Yako
Okay. Great. Thank you.
Operator
Thank you. This conclude today's question-and-answer session. I would like to turn the call back to Peter Salkowski for closing remarks.
Peter Salkowski
Thank you, Sarah. I would like to thank everyone for joining the call today and let you know that Fortinet will be attending the following investor conferences in San Francisco during the first quarter. We will be at the Goldman Sachs conference next week on February 11th and we will be at the Morgan Stanley conference also in San Francisco on March 3rd.
Presentations for both of these events will be webcast and links to these webcast will be available on the investor relations website for Fortinet. If you have any follow-up questions, please feel free to contact me. Have a great rest of your day. Thank you.
Operator
Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect.
