Fortinet, Inc. annual report, FY2017

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Fortinet, Inc. — FY2017 Form 10-K

Reporting period: Fiscal year ended December 31, 2017. This is an annual filing, not a standalone fourth-quarter filing; quarterly figures below are included for context. Fortinet sells cybersecurity appliances, software, subscriptions and support, principally through distributors and resellers. Financial statements received an unqualified audit opinion; management and the auditor concluded internal control over financial reporting was effective at year-end.

Financial performance and position

  • Revenue: $1.495 billion, up 17% from $1.275 billion in 2016. Product revenue rose 5% to $577.2 million; service revenue rose 26% to $917.8 million and represented 61% of total revenue.
  • Profitability: Gross profit was $1.110 billion; gross margin was 74.2%, up 0.7 percentage points. Operating income increased 156% to $109.8 million, with a 7.3% operating margin. Net income was $31.4 million ($0.18 diluted per share), versus $32.2 million ($0.18) in 2016.
  • Cash generation: Operating cash flow was $594.4 million, up 72%; non-GAAP free cash flow was $459.1 million versus $278.5 million. Capital expenditures were $135.3 million.
  • Liquidity: Cash, cash equivalents and investments totaled $1.349 billion, including $811.0 million of cash and cash equivalents. Working capital was $689.6 million. Deferred revenue was $1.336 billion, up 29%.
  • Debt and obligations: The reported balance sheet does not show a borrowings or debt line. Total liabilities were $1.669 billion. Contractual obligations totaled $154.0 million, including $97.2 million of inventory purchase commitments, largely due within one year.
  • Capital returns: Fortinet repurchased 11.2 million shares for $446.3 million during 2017; $442.8 million remained authorized. No cash dividends were paid or anticipated in the foreseeable future.

Material changes and unusual items

  • Service revenue grew much faster than product revenue, continuing the shift toward recurring subscriptions and support. Billings, a non-GAAP measure, increased 19% to $1.796 billion.
  • Service gross margin rose to 84.6%, while product gross margin fell to 57.8% from 61.9%. Management attributed the product-margin decline partly to longer-term deals and higher-priced service bundles, which allocate more contract value to services while product costs are recognized at shipment. Overall gross margin improved modestly.
  • Operating expenses rose 12% to $999.8 million, but declined as a share of revenue to 67% from 70%; sales and marketing fell to 47% of revenue from 49%.
  • Net income was affected by a 75% effective tax rate, including provisional charges of $47.9 million for remeasuring deferred tax assets after U.S. tax-rate reductions and $15.2 million for the transition tax. Excluding the 2017 Tax Act effects, management reported an effective tax rate of 24%.
  • Fourth-quarter revenue was $416.7 million. The quarter recorded a $29.0 million net loss, principally reflecting a $74.0 million income-tax provision, including tax-law effects.
  • Real-estate purchases contributed to capital spending: 2017 capital expenditures included $107.2 million for property purchases. Fortinet expected 2018 capital expenditures of $90–$120 million.

Outlook, commentary and risks

  • Management expected 2018 overall gross margin to remain at a relatively comparable level. It expected research and development, sales and marketing, and general and administrative expenses to increase in absolute dollars, while continuing to invest in enterprise sales and marketing.
  • Revenue recognition guidance adopted January 1, 2018 was expected to have no material revenue impact overall. Fortinet expected to capitalize at least $130 million of eligible sales commissions on existing service contracts, changing expense timing rather than contract cash flows.
  • Management stated existing cash and cash equivalents were expected to cover anticipated needs for at least 12 months. It planned to repatriate certain previously indefinitely reinvested foreign earnings under the new tax regime; related tax accounting remained provisional.
  • Key risks include reliance on channel partners and distributor concentration: Exclusive accounted for 25% of 2017 revenue, 30% of fourth-quarter revenue (combined with Fine Tec U.S.) and 35% of year-end net receivables. This creates meaningful exposure to partner performance and collections.
  • Other material risks include intense competition and pricing pressure; component shortages and reliance on third-party manufacturers; inventory forecasting; product defects or security failures; foreign exchange exposure; and dependence on recurring-service renewals. A U.S. Attorney’s Office inquiry into Trade Agreements Act compliance remained ongoing. The filing also describes ongoing litigation and tax uncertainties, including a French tax audit.
  • In February 2018, CFO Drew Del Matto resigned and Keith Jensen was appointed interim CFO. Fortinet also reported launching the FortiGate 6000 series in February 2018.

Investor verification priorities

  1. Confirm the durability and quality of growth in service revenue, deferred revenue and billings, including renewal rates and contract duration.
  2. Monitor distributor concentration, especially Exclusive/Fine Tec U.S., for receivables collection, channel inventory and any change in order patterns.
  3. Assess whether product-margin pressure persists and whether enterprise and Security Fabric investments continue to improve operating leverage.
  4. Track final accounting for the 2017 Tax Act, the effective tax rate, repatriation costs and uncertain tax positions.
  5. Review execution of the 2018 capital-spending plan and the effect of repurchases on liquidity and share count.
  6. Follow the Trade Agreements Act inquiry, French tax audit, CFO transition and adoption of new revenue-recognition accounting.