Fortinet, Inc. — Q2 2020 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2020. Amounts are in U.S. dollars; financial-statement figures are in millions unless noted.
Business context
Fortinet sells cybersecurity hardware, software, subscriptions and technical support, primarily through distributors and other channel partners. It reports one operating segment. Service revenue, including FortiGuard subscriptions and FortiCare support, represented 66% of Q2 revenue.
Financial performance
| Metric | Q2 2020 | Q2 2019 | Six months 2020 | Six months 2019 |
|---|---|---|---|---|
| Revenue | $615.5 (+18%) | $521.7 | $1,192.4 (+20%) | $994.3 |
| Product revenue | $211.9 (+12%) | $189.9 | $404.2 (+15%) | $352.6 |
| Service revenue | $403.6 (+22%) | $331.8 | $788.2 (+23%) | $641.7 |
| Gross profit / margin | $480.4 / 78.1% | $393.4 / 75.4% | $928.6 / 77.9% | $753.0 / 75.7% |
| Operating income / margin | $116.7 / 19% | $75.2 / 14% | $232.6 / 20% | $125.8 / 13% |
| Net income | $112.1 | $72.7 | $216.1 | $131.5 |
| Diluted EPS | $0.68 | $0.42 | $1.27 | $0.75 |
| Operating cash flow | $247.0 | $195.1 | $566.4 | $396.4 |
Q2 billings, a non-GAAP measure, were $711.5 million, up 14%. Q2 free cash flow, as defined by Fortinet, was $216.1 million versus $177.8 million. Six-month operating cash flow included $50 million received under an IP agreement.
Liquidity, capital and balance sheet
- Cash, cash equivalents and investments totaled $1.63 billion at June 30, down from $2.21 billion at December 31, 2019. Working capital was $596.8 million, compared with $1.30 billion at year-end.
- Operating cash generation was more than offset by $1.046 billion of share repurchases and $58.9 million of taxes paid on net-settled equity awards. Cash and cash equivalents declined $306.1 million over the six months.
- Deferred revenue was $2.32 billion, up 9% from year-end. Remaining performance obligations were also $2.32 billion; Fortinet expected about $1.28 billion to be recognized over the next 12 months.
- The filing reports no borrowings or debt balance. Total liabilities were $2.79 billion, including $2.32 billion of deferred revenue. The company said existing cash and cash equivalents should cover anticipated needs for at least 12 months.
- Fortinet repurchased 11.4 million shares for approximately $1.05 billion in the first half. At June 30, $546.8 million remained authorized; in July the board added $500 million and extended the program through February 2022. As of August 6, $1.05 billion remained available.
Changes, unusual items and outlook
- Growth in both product and service revenue was broad-based across regions. Management cited FortiGate, SD-WAN, cloud, endpoint, teleworker and remote-security products, along with subscription and support revenue. EMEA was the largest contributor to Q2 revenue growth by dollars.
- Gross margin improved year over year, helped by higher software mix and lower hardware costs as a share of product revenue, as well as service-cost efficiencies. Operating expenses increased, including from personnel investment; lower travel and event spending during the pandemic partly offset sales and marketing costs.
- A competitor paid $50 million in February under a 14-year mutual patent covenant-not-to-sue agreement. Fortinet recognized $37.9 million as an operating gain in the first half ($1.1 million in Q2); the remaining transaction consideration is to be recognized over time. The gain materially contributed to first-half operating income growth.
- Other unusual items included a $4.3 million first-quarter impairment of a privately held investment and lower interest income due to falling rates and reduced invested balances.
- Management did not provide numerical revenue or earnings guidance in the supplied filing text. It expected R&D, sales and marketing, and general and administrative expenses to remain at or increase in absolute dollars during the rest of 2020. Estimated 2020 spending on the headquarters expansion was $100–$110 million; completion was delayed to early 2021.
- COVID-19 effects were uncertain. Management reported extended payment terms for some distributors, lengthening sales cycles for some customers, reduced travel and events, and increased inventory buffers; suppliers delivered over 90% of commitments and backlog was in line with historical averages. The company warned that the pandemic and economic downturn could materially affect future demand, sales cycles, supply, margins, cash flows and liquidity.
- Key exposures include reliance on channel partners and distributor concentration: Exclusive Networks represented 31% of Q2 revenue and 31% of net receivables at quarter-end; Ingram Micro represented 11% of net receivables. The filing also identifies competition, cybersecurity and product vulnerabilities, component and manufacturing dependencies, foreign exchange, tax audits and litigation as risks. Inventory purchase commitments were $282.1 million, including $281.8 million due in 2020; other non-cancelable commitments exceeding one year were $27.8 million.
- After quarter-end, Fortinet acquired OPAQ Networks for approximately $13 million in cash, subject to adjustments. Purchase accounting was still being evaluated. Disclosure controls were assessed as effective at June 30, 2020.
Important facts for investors to verify
- Whether billings, deferred revenue and remaining performance obligations continue to translate into recognized revenue and cash collection, particularly given extended customer payment terms.
- How much of reported operating-income growth reflects recurring operations versus the $37.9 million first-half IP gain.
- Whether the substantial repurchases and expanded authorization leave adequate liquidity for capital spending, acquisitions and pandemic-related needs.
- Distributor concentration and credit exposure, including the financial condition and payment performance of Exclusive Networks and Ingram Micro.
- Whether COVID-19-related demand, sales-cycle, supply-chain and inventory risks materially change after the reporting date, and the integration and accounting outcomes for OPAQ.