Fortinet, Inc. — Form 10-Q Summary
Reporting period: Quarter and nine months ended September 30, 2019. Amounts are in U.S. dollars; financial statement figures are in millions unless noted. Results are unaudited.
Business context and reporting period
Fortinet sells cybersecurity hardware and software, security subscriptions, technical support, and related services through a primarily channel-based model. Its offerings include network, infrastructure, cloud, IoT and operational technology security. The company reports one operating and reportable segment.
Financial performance
- Revenue: Q3 revenue was $547.5 million, up 21% year over year; nine-month revenue was $1,541.8 million, up 19%. Q3 product revenue rose 20% to $197.1 million and service revenue rose 21% to $350.4 million. For the nine months, product revenue grew 16% to $549.7 million and service revenue grew 21% to $992.1 million.
- Profitability: Q3 gross profit was $423.4 million and gross margin was 77.3%, versus 75.4% a year earlier. Operating income was $100.0 million, up 59%, with an operating margin of approximately 18.3%, versus approximately 13.8%. Net income was $79.8 million, up from $58.7 million; diluted EPS was $0.46 versus $0.33.
- Nine-month profitability: Gross profit was $1,176.4 million and gross margin was 76.3%, versus 75.1%. Operating income was $225.8 million, up 55%, and net income was $211.3 million versus $149.6 million. Diluted EPS was $1.21 versus $0.86.
- Cash flow: Operating cash flow was $617.6 million for the nine months, up 35% from $458.7 million. Capital expenditures were $45.0 million, implying nine-month free cash flow of approximately $572.6 million under the company’s definition. Q3 operating cash flow was $221.2 million and reported non-GAAP free cash flow was $203.7 million.
- Liquidity and debt: Cash, cash equivalents and investments totaled $2,144.5 million at September 30, up from $1,716.6 million at year-end 2018. Working capital was $1,124.3 million. The balance sheet lists no debt balance; the filing text does not provide a clear discussion of borrowing capacity.
- Deferred revenue and obligations: Deferred revenue was $1,945.6 million, up 15% from December 31, 2018. Remaining performance obligations were $1.95 billion; approximately $1.06 billion was expected to be recognized over the next 12 months. Q3 billings, a non-GAAP measure, were $626.6 million, up 19%.
Material changes versus comparable periods
- Q3 revenue growth reflected both products and services, with service revenue benefiting from recognition of prior-period subscription and support billings. FortiGuard security subscription revenue grew 23% in Q3; technical support and other service revenue grew 19%.
- All reported regions grew in Q3: Americas revenue increased 24%, EMEA 21%, and APAC 12%. The Americas contributed the largest absolute dollar increase.
- Gross margin improved year over year, supported by lower product costs as a percentage of product revenue and service growth outpacing related personnel costs. Operating expenses grew in dollars but declined as a share of revenue.
- Cash used in investing activities increased to $402.7 million from $7.4 million, mainly reflecting net investment purchases of $357.7 million and $45.0 million of capital expenditures. Financing cash use was $151.8 million, including $117.6 million for share repurchases.
- Cash and investments rose despite repurchases; the company also reported a substantial decline in cash and investments held by international subsidiaries, attributed to changes in its international tax structure.
Outlook, commentary, risks and unusual items
- Management expected research and development, sales and marketing, and general and administrative expenses to increase in absolute dollars during the remainder of 2019. It estimated $35 million to $45 million of 2019 spending on its new headquarters project. The filing provides no formal revenue or earnings guidance figures.
- Management said existing cash and cash equivalents should cover anticipated cash needs for at least the next 12 months. It cited growth, repurchases, product development, sales and marketing investment, real estate and acquisitions as factors affecting future capital needs.
- Q3 other expense included a $3.8 million non-cash impairment charge on a privately held investment; the comparable 2018 quarter included a $2.2 million gain on sale of an investment. Q3 tax expense included a $2.9 million increase related to settlement of foreign tax audits. Nine-month tax expense included a $10.3 million uncertain tax benefit accrual related to the Altera decision and a $10.0 million release of uncertain-tax-position reserves.
- Fortinet disclosed a second-quarter 2019 cyber incident involving an unauthorized party that targeted the company, including attempts to impersonate firewall update servers. The investigation was substantially complete; management did not believe the incident had a material business or customer impact and was not aware of claims arising from it.
- Key risks include quarterly sales and shipment timing, reliance on channel partners and concentrated distributors, product and service vulnerabilities, competition and pricing pressure, component supply and manufacturing constraints, international and foreign-exchange exposure, tax uncertainty, and litigation. Exclusive Networks accounted for 30% of Q3 revenue and 32% of net accounts receivable at September 30; Ingram Micro represented 11% of each relevant measure as disclosed.
- Open inventory purchase commitments that may not be cancelable totaled $241.4 million, primarily due by the end of 2020. Other non-cancelable contractual commitments with remaining terms over one year were $12.6 million. The filing states that litigation outcomes are uncertain but that management was not aware of claims or proceedings it believed likely to materially harm financial position.
- After quarter-end, Fortinet acquired endpoint detection and response company enSilo for approximately $20.0 million in initial consideration. It also repurchased 0.3 million shares for $23.5 million through the filing date. The company adopted lease accounting standard Topic 842 in 2019, recognizing operating-lease right-of-use assets and liabilities; management reported no material impact on income or cash flows.
Important facts for investors to verify
- Whether subscription and support demand, renewals, billings and deferred-revenue growth continue to support reported revenue growth.
- Whether gross-margin and operating-margin gains persist as Fortinet expands headcount and increases operating spending.
- Exposure to distributor concentration, particularly Exclusive Networks, and the collectability of concentrated receivables.
- Potential customer, legal, reputational or financial consequences of the disclosed cyber incident and the effectiveness of remediation.
- Tax audit and Altera-related developments, uncertain tax positions, and their effect on future effective tax rates.
- Execution, integration and purchase-accounting outcomes for enSilo; headquarters project costs; and the scale and timing of future repurchases and capital commitments.