Fortinet, Inc. — Q2 2013 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2013. Financial statements are unaudited. Amounts below are in U.S. dollars; financial figures are in millions unless otherwise noted.
Business context
Fortinet provides network security appliances, software, subscriptions and support services, selling primarily through channel partners. FortiGate products are its core offering. Subscription and support revenue is generally recognized over the service term, so deferred revenue provides visibility into revenue to be recognized in future periods.
Key financial metrics
| Metric | Q2 2013 | Q2 2012 | Six months 2013 | Six months 2012 |
|---|---|---|---|---|
| Revenue | $147.4 | $129.0 | $283.2 | $246.2 |
| Gross profit | $103.7 | $91.8 | $200.4 | $178.0 |
| Gross margin | 70.4% | 71.2% | 70.8% | 72.3% |
| Operating income | $13.8 | $21.0 | $29.2 | $39.7 |
| Net income | $9.0 | $14.0 | $21.2 | $28.1 |
| Diluted EPS | $0.05 | $0.08 | $0.13 | $0.17 |
| Operating cash flow | $37.2 | $44.3 | $75.3 | $92.8 |
Q2 operating margin was approximately 9%, versus 16% a year earlier. For the six-month period, total revenue grew 15%; product revenue increased 8% to $124.5 million, and services revenue increased 22% to $155.6 million. No debt is presented as a balance-sheet line item in the filing.
- Liquidity: Cash and cash equivalents of $123.5 million and investments of $690.9 million totaled $814.4 million at June 30, up $74.8 million from year-end 2012. Working capital was $311.9 million. Current assets were $672.4 million and current liabilities $360.5 million.
- Deferred revenue: $389.7 million, up $26.5 million from December 31, 2012; $124.0 million was non-current.
- Cash generation and investment: Six-month operating cash flow was $75.3 million. Investing activities used $91.5 million, including $82.0 million of net investment purchases, $6.0 million for the Coyote acquisition and $3.6 million in property and equipment purchases. Financing activities provided $17.5 million.
- Non-GAAP measures: Q2 billings were $160.7 million and free cash flow was $35.2 million, as defined by the company. These are non-GAAP measures and should be considered alongside GAAP results.
Material changes versus the prior comparable periods
- Q2 revenue grew 14%, led by services growth of 22%; product revenue increased 8%. Revenue increased in all regions: Americas and EMEA each grew 16%, and APAC grew 10%.
- Despite higher revenue, Q2 operating income fell 34% and net income fell 36% year over year. Operating expenses rose 27%, reflecting hiring and spending on product development and sales coverage.
- Gross margin declined 0.8 percentage points in Q2 and 1.5 points for the first half. Management attributed pressure to entry-level product mix and higher overhead, expanded technical support, and growth in lower-margin consulting services.
- Six-month operating cash flow declined 19%. Management cited a larger inventory build ($16.4 million use of cash) and an increase in other assets ($12.4 million use), partly offset by deferred-revenue growth and timing-related increases in payables and taxes.
- Headcount rose to 2,182 from 1,762 a year earlier. Stock-based compensation was $10.7 million in Q2 and $20.0 million for the first half.
Outlook, risks and unusual items
- Outlook: The filing provides no numeric revenue or earnings guidance. Management expected R&D, sales and marketing, and G&A expense as a percentage of revenue to remain at approximately comparable levels during the remainder of fiscal 2013. It stated existing cash, cash equivalents and investments should meet anticipated needs for at least 12 months.
- Management commentary: Growth was supported by FortiGate products, particularly entry-level appliances, wireless security and access points, and by subscription and support revenue from a larger installed customer base. Management noted slower U.S. service-provider sales and fewer deals above $500,000 for the first half, while deals above $100,000 and $250,000 increased.
- Operating and market risks: Results may fluctuate with quarter-end order concentration, channel demand, service renewals, product mix, competition and pricing, product launches, and large-customer purchasing cycles. The company also cited inventory forecasting and shortages, reliance on third-party manufacturers and limited-source components, international and currency exposure, and product defects or security vulnerabilities.
- Commitments and litigation: Contractual commitments included $39.8 million in potentially non-cancelable manufacturer purchase orders and $29.8 million in operating lease payments. Patent cases involving Network Protection Sciences and SRI remained pending; the NPS trial was scheduled for September 2013. The company stated it did not then believe the disclosed litigation would have a material adverse effect and did not consider a loss reasonably possible in the cases discussed in the notes.
- Taxes: The Q2 effective tax rate was 40%, versus 37% a year earlier; the first-half rate was 34%, versus 33%. Unrecognized tax benefits were $31.2 million, with approximately $2.2 million accrued for related interest. A California tax audit was ongoing; the company did not expect a significant adverse effect. It said uncertain tax benefits could decrease by up to $1.1 million within 12 months.
- Acquisition and other items: Fortinet acquired Coyote Point Systems for approximately $6.0 million in cash, with potential earn-out payments of up to $5.5 million contingent on future objectives and service. Q2 results included $0.5 million of patent settlement income, which management excluded from its non-GAAP measures. The company also changed its non-GAAP presentation in Q2 to exclude amortization of certain intangible assets.
Important facts for investors to verify
- Whether services growth and deferred-revenue additions continue to support billings and future recognized revenue.
- Whether operating expenses and hiring can be absorbed without further pressure on operating margin and earnings.
- Whether lower product and services gross margins stabilize, and how product mix and support costs evolve.
- Whether inventory levels, component availability and the $39.8 million of purchase commitments are aligned with demand.
- How the pending patent cases, uncertain tax positions and Coyote contingent earn-out affect future cash flows or expenses.
- The composition and accessibility of liquidity: $63.6 million of cash was held by international subsidiaries and was not immediately available for domestic operations without repatriation and potential U.S. tax.