Fortinet, Inc. — Q3 2016 Form 10-Q
Business context and reporting period. Fortinet sells cybersecurity appliances, software and related subscription and technical-support services through a primarily distributor-led channel. This unaudited filing covers the three and nine months ended September 30, 2016; comparisons are to the corresponding 2015 periods.
Financial performance and liquidity
| Metric | Q3 2016 | Q3 2015 | Change |
|---|---|---|---|
| Revenue | $316.6 million | $260.1 million | +22% |
| Product revenue | $128.0 million | $119.7 million | +7% |
| Service revenue | $188.7 million | $140.3 million | +34% |
| Gross margin | 73.2% | 72.4% | +0.8 percentage points |
| Operating income (loss) | $5.5 million | $(1.8) million | Improved |
| Net income | $6.3 million | $8.2 million | Down |
| Diluted earnings per share | $0.04 | $0.05 | Down |
For the nine months, revenue was $912.6 million, up 28%; product revenue grew 17% and service revenue 37%. Gross margin was 72.9%, versus 71.3%. Operating loss was $2.2 million versus operating income of $2.0 million, while net income was $7.0 million versus $10.5 million. The nine-month tax benefit of $7.4 million contributed to positive net income despite a pretax loss of $0.4 million.
Q3 billings, a company-defined non-GAAP measure, were $347.5 million versus $299.6 million. Deferred revenue was $934.8 million, up $143.5 million, or 18%, from December 31, 2015. Management attributed growth chiefly to FortiGate sales and recurring FortiGuard and FortiCare services; services represented 60% of Q3 revenue, compared with 54% a year earlier.
At September 30, cash and cash equivalents were $647.5 million and investments were $623.1 million, totaling $1.271 billion, up $106.3 million from year-end. Working capital was $644.5 million. Operating cash flow for the nine months was $244.7 million, versus $214.0 million; Q3 operating cash flow was $76.1 million. Q3 free cash flow, as defined by the company, was $70.2 million. The balance sheet presents no debt line; the filing does not provide a clear total-debt figure.
Nine-month investing cash outflow was $76.2 million, including $50.3 million of capital expenditures and $22.1 million for the AccelOps acquisition. Financing cash outflow was $64.2 million, including $75.0 million of share repurchases. The company had $116.5 million of potentially non-cancelable inventory purchase commitments and $74.1 million of operating lease commitments.
Material changes and notable items
- Revenue growth continued, but product growth lagged service growth. Q3 product revenue was affected by North American sales execution issues, Brexit-related macroeconomic challenges in the U.K. and geopolitical issues in Latin America.
- Operating expenses rose 19% in Q3 and 32% for the nine months, reflecting hiring and investment in sales, marketing, R&D and customer support. Headcount was up 19% year over year to 4,619 employees and contractors. Q3 sales and marketing expense rose 28%.
- Q3 overall gross margin improved as the higher-margin service mix expanded. Product gross margin slipped 0.7 percentage points in Q3, partly due to higher inventory reserves and overhead costs; nine-month product and service margins both improved year over year.
- Fortinet acquired AccelOps in June for $22.1 million net cash consideration. The purchase accounting added $9.9 million of goodwill and $14.9 million of finite-lived intangible assets. The acquisition’s results were considered immaterial for pro forma disclosure.
- The company early-adopted ASU 2016-09 on stock compensation. The adoption included a $32.4 million cumulative retained-earnings adjustment and contributed tax benefits; it also changed forfeiture accounting. Q1 2016 results were retrospectively adjusted, including a change from a reported $3.4 million net loss to adjusted net income of $2.1 million.
- A January 2016 repurchase program authorized up to $200 million through December 2017; $75 million had been repurchased through September 30, with $125 million remaining. In October, the board added $100 million, raising authorization to $300 million.
Outlook, risks and contingencies
The filing gives no specific revenue or earnings guidance. Management expected R&D expense as a share of revenue to remain relatively comparable for the rest of 2016, sales and marketing expense as a share of revenue to decrease slightly, and G&A expense as a share of revenue to remain relatively comparable. It expected $15–$25 million of remaining-2016 capital expenditures and approximately $1.2 million of additional restructuring charges in Q4, within an estimated $4.1 million total for the 2016 restructuring. Management stated existing cash and cash equivalents were sufficient for anticipated needs for at least 12 months.
Key risks include sales execution and the productivity ramp of the realigned sales organization; competitive and macroeconomic pressures; reliance on distributors (Exclusive Networks represented 19% of Q3 revenue and Ingram Micro 10%); quarter-end sales concentration; component supply and inventory management; foreign-exchange exposure; and successful integration and operation of the new ERP system. More than 40% of Q3 billings occurred in the final two weeks, compared with an eight-quarter average of 34%.
Some $501.4 million of cash and investments were held by international subsidiaries and were not immediately available for domestic use without repatriation. The company was considering repatriating some cash in December 2016; any repatriation would be subject to U.S. federal tax, which management expected to be offset by foreign tax credits. Tax authorities were examining U.S. federal returns for 2012–2014; France was reviewing intercompany relationships, and Japan was auditing 2013–2015 returns. Management did not expect material Japanese audit adjustments. The company reported ongoing litigation but no significant loss accrual and said it believed no current matter was likely to materially harm its financial position.
Important facts for investors to verify
- Whether service revenue, deferred revenue and billings growth continue, and how renewals and service-contract duration affect future recognized revenue.
- Whether sales execution improves, especially in North America, and whether the increased sales and marketing investment produces growth and operating leverage.
- Whether operating profitability recovers as expenses rise; assess the effects of stock-based compensation, restructuring, ERP costs and the unusual tax benefits on reported earnings.
- Whether inventory reserves, component availability and non-cancelable purchase commitments create margin or working-capital pressure.
- How much cash is repatriated, any resulting tax impact, and the pace and price of repurchases under the expanded authorization.
- Developments in tax examinations, litigation, AccelOps integration and ERP controls; management reported disclosure controls were effective at September 30, 2016.