Fortinet, Inc. — Form 10-Q Summary
Reporting period: Quarter and nine months ended September 30, 2015. Fortinet provides cybersecurity products and related subscription and technical-support services. Figures are in U.S. dollars; financial statement amounts are in millions unless noted.
Financial performance and liquidity
| Metric | Q3 2015 | Q3 2014 | Nine months 2015 | Nine months 2014 |
|---|---|---|---|---|
| Revenue | $260.1 | $193.3 | $712.7 | $546.4 |
| Product revenue | $119.7 | $87.7 | $332.0 | $249.9 |
| Service revenue | $140.3 | $105.6 | $380.7 | $296.5 |
| Gross margin | 72.4% | 70.6% | 71.3% | 69.7% |
| Operating income (loss) | $(1.8) | $15.5 | $2.0 | $39.4 |
| Net income | $8.2 | $4.1 | $10.5 | $18.5 |
| Diluted EPS | $0.05 | $0.02 | $0.06 | $0.11 |
- Growth: Q3 revenue rose 35% year over year; excluding Meru Networks, acquired in July, growth was 28%. Nine-month revenue increased 30%, or 28% excluding Meru. Product and service revenue grew across all regions.
- Profitability: Gross margin improved in both periods, with management citing product mix, software sales, inventory efficiencies, and service-scale efficiencies. Operating expenses rose 57% in Q3 and 48% for the nine months; sales and marketing was the largest expense increase. Q3 operating results included a $5.9 million restructuring charge.
- Tax effects: Q3 net income benefited from a $9.3 million income-tax benefit despite a $1.2 million pretax loss. The nine-month tax benefit was $6.6 million. Discrete tax items included a U.S. Tax Court-related benefit and releases or adjustments to tax benefits; reported effective tax rates were unusually high or negative.
- Cash flow: Nine-month operating cash flow was $214.0 million, compared with $161.2 million a year earlier. Capital expenditures were $29.0 million, yielding nine-month free cash flow of approximately $185.0 million. In Q3, operating cash flow was $65.1 million and free cash flow was $51.7 million, versus $56.5 million and $50.7 million, respectively.
- Liquidity: Cash, cash equivalents, and investments totaled $1.170 billion at September 30, 2015, up from $991.7 million at year-end 2014. Working capital was $648.6 million. Deferred revenue was $706.9 million, up 27% from year-end and 41% year over year; it primarily reflects unrecognized subscription and support revenue.
- Debt and obligations: The balance sheet does not show borrowings or debt. Contractual commitments totaled $170.8 million, including $76.0 million in inventory purchase commitments and $56.8 million in operating leases.
Material changes and notable items
- Fortinet acquired Meru Networks for total consideration of $41.8 million. Meru contributed $12.0 million of revenue and a $9.6 million net loss from acquisition through quarter-end. Acquisition-related costs of $1.7 million were expensed; purchase-price allocation remained subject to adjustment.
- Meru-related restructuring was estimated at $6.3 million in total. Fortinet recorded $5.9 million in Q3 and expected the remainder in Q4 2015 and 2016; associated cash payments were expected through fiscal 2017.
- Operating expenses increased alongside accelerated hiring and investment in sales, marketing, R&D, support, and ERP implementation. Headcount rose 43% year over year to 3,889.
- A $1.6 million impairment of Coyote Point-acquired intangible assets was recorded in Q2 2015.
- Stock-based compensation was $67.0 million for the nine months, versus $42.3 million in the prior-year period.
Outlook, risks, and contingencies
- Management expected R&D, sales and marketing, and general and administrative expense as a percentage of revenue to decrease during the remainder of 2015, while continuing investment in product development and sales resources. Planned capital expenditures were $8 million to $13 million, mainly for offices and ERP implementation.
- Management believed existing cash and cash equivalents would meet anticipated needs for at least 12 months. It reported $371.9 million of cash and investments held by foreign subsidiaries and said it did not intend to repatriate those funds.
- Management emphasized continued growth opportunities in large enterprises and service providers, but cautioned that results may vary and that growth, billings, and profitability may not be sustained. Key exposures include intense competition and pricing pressure, reliance on channel partners and contract manufacturers, component supply constraints, quarter-end shipment concentration, customer renewal trends, cybersecurity product defects or breaches, foreign exchange, international operations, and acquisition integration.
- Fortinet reported ongoing litigation and patent disputes but had not recorded a significant loss contingency; management said no existing claim was then expected to have a material adverse effect, while noting outcomes were uncertain. Unrecognized tax benefits were $55.8 million, with $5.0 million accrued for estimated interest; tax examinations and changes in tax estimates could affect results.
- The company reported effective disclosure controls as of September 30, 2015, and no material change in internal control over financial reporting during the nine-month period.
Most important facts for investors to verify
- Whether underlying revenue, billings, and deferred-revenue growth persist excluding Meru; Q3 billings were $299.6 million, up 41% reported and 33% excluding Meru.
- Whether expense growth moderates as management anticipated and operating profitability recovers after the Q3 operating loss.
- How Meru performs and whether integration, restructuring costs, and purchase accounting produce the expected strategic and operational benefits.
- The sustainability of cash generation and gross-margin improvements, including the effects of stock-based compensation and working-capital timing.
- Potential changes in tax benefits, uncertain tax positions, litigation exposure, customer/channel concentration, and supply-chain or cybersecurity risks.