Business context and reporting period
Fortinet, Inc. filed this unaudited Form 10-Q for the quarter ended September 30, 2014. Fortinet sells network-security appliances, principally its FortiGate platform, and related subscription and technical-support services worldwide. All dollar amounts below are in U.S. dollars; financial statement amounts are in millions unless noted.
Financial performance and position
| Metric | Q3 2014 | Q3 2013 | Nine months 2014 | Nine months 2013 |
|---|---|---|---|---|
| Revenue | $193.3 | $154.7 | $546.4 | $437.9 |
| Product revenue | $87.7 | $69.7 | $249.9 | $194.2 |
| Services and other revenue | $105.6 | $85.0 | $296.5 | $243.8 |
| Gross margin | 70.6% | 71.6% | 69.7% | 71.1% |
| Operating income | $15.5 | $18.3 | $39.4 | $47.4 |
| Net income | $4.1 | $11.0 | $18.5 | $32.3 |
| Diluted EPS | $0.02 | $0.07 | $0.11 | $0.19 |
- Revenue grew 25% in both the quarter and nine-month period. Management attributed growth to FortiGate demand and services revenue recognized from a larger deferred-revenue base.
- Operating expenses rose 31% in Q3 and 30% for nine months, chiefly from hiring and increased sales and marketing investment. Sales and marketing expense rose 42% in Q3 and 37% for nine months.
- Cash, cash equivalents and investments totaled $963.8 million at September 30, 2014, versus $843.0 million at December 31, 2013. Working capital was $461.9 million. Deferred revenue was $500.0 million, up from $432.6 million at year-end.
- For the first nine months, operating cash flow was $161.2 million versus $100.7 million. Q3 operating cash flow was $56.5 million versus $25.4 million; non-GAAP free cash flow was $50.7 million versus $22.2 million. Nine-month capital expenditures were $26.8 million.
- The filing reports no borrowings or debt balance on the balance sheet. Total liabilities were $663.4 million, including deferred revenue and tax payables.
- Effective tax rates were 74% for Q3 and 55% for the first nine months, compared with 40% and 36%, respectively, in 2013.
Material changes versus the prior comparable period
- Despite 25% revenue growth, Q3 net income fell 63% year over year; nine-month net income fell 43%. Higher operating expenses and sharply higher effective tax rates were major factors.
- Gross margin declined 1.0 percentage point in Q3 and 1.4 points for nine months. Management cited lower product margins, including product mix and higher overhead in Q3, and a $2.4 million Coyote intangible-asset impairment, higher warranty costs and inventory write-offs for the nine-month decline.
- Headcount increased to 2,721 from 2,238 a year earlier as Fortinet expanded sales, marketing, product development and customer support.
- Nine-month operating cash flow increased 60%; the company received $20.0 million in January under a six-year mutual covenant-not-to-sue and release agreement with Palo Alto Networks. The filing identifies this receipt as one source of operating cash.
- Fortinet repurchased 1.4 million shares for $33.2 million during the first nine months. The board extended the repurchase authorization through December 31, 2015; $124.9 million remained authorized as of October 17, 2014.
Outlook, management commentary and risks
- No specific revenue or earnings guidance is provided. Management expected R&D expense as a percentage of revenue to remain at similar levels for the rest of fiscal 2014; sales and marketing expense as a percentage of revenue to remain similar or increase; and G&A expense as a percentage of revenue to remain similar.
- Management expected up to $7.0 million of capital expenditures for the remainder of fiscal 2014 and believed available cash and cash equivalents would meet anticipated needs for at least 12 months. $233.4 million of cash and investments was held by international subsidiaries and was not immediately available for domestic use without repatriation and potential U.S. tax.
- The company cited demand for newer FortiGate products, including enterprise data-center appliances, and continued investment in sales capacity and marketing. Revenue is substantially generated through channel partners; Exclusive Networks Group represented 15% of Q3 revenue and Fine Tec Computer 11%.
- Key disclosed risks include unpredictable quarterly results and late-quarter shipment concentration; competition and pricing pressure; dependence on channel partners and recurring subscriptions/support; inventory and component-supply constraints; product defects or security failures; foreign-exchange exposure; and tax-rate uncertainty.
- Unusual items include the $2.4 million Coyote intangible impairment and the reevaluation of functional currency for certain foreign subsidiaries, with related effects recorded prospectively and a cumulative impact included in Q3 operations. The company also reported $39.4 million of unrecognized tax benefits and $1.6 million of accrued interest on uncertain tax positions.
- Management reported disclosure controls were effective as of September 30, 2014, with no material change in internal control over financial reporting during the quarter. The filing states no current litigation matter is expected to have a material adverse effect, while noting ordinary-course claims and litigation risks.
Most important facts for investors to verify
- Whether revenue and deferred-revenue growth continue, particularly for subscriptions and support, and whether distributor concentration or channel inventory changes.
- Whether sales and marketing investment converts into growth without further pressure on operating income and margins.
- Whether the elevated effective tax rate persists, including developments in tax reserves, foreign taxes and research-credit availability.
- Whether product gross margins recover after the reported product-mix, warranty, inventory and Coyote impairment effects.
- Cash-flow quality: the contribution of deferred-revenue growth and the $20.0 million Palo Alto Networks payment, alongside capital spending and share repurchases.
- Potential exposure from supply constraints, foreign exchange, litigation/IP claims and implementation of the new revenue-recognition standard, which Fortinet was still evaluating.