Fortinet, Inc. — Q3 2017 Form 10-Q
Reporting period: Three and nine months ended September 30, 2017; compared with the corresponding 2016 periods. Amounts below are in U.S. dollars unless noted. Fortinet provides cybersecurity products, software and subscription services, primarily through distributors and other channel partners.
Financial performance
| Metric | Q3 2017 | Q3 2016 | Nine months 2017 | Nine months 2016 |
|---|---|---|---|---|
| Revenue | $374.2m | $316.6m | $1,078.3m | $912.6m |
| Product revenue | $137.1m | $128.0m | $415.1m | $389.2m |
| Service revenue | $237.1m | $188.7m | $663.2m | $523.4m |
| Gross margin | 75.0% | 73.2% | 74.0% | 72.9% |
| Operating income (loss) | $33.7m | $5.5m | $67.6m | $(2.2)m |
| Net income | $26.6m | $6.3m | $60.4m | $7.0m |
| Diluted EPS | $0.15 | $0.04 | $0.34 | $0.04 |
Revenue grew 18% in both periods year over year. Service revenue grew 26% in Q3 and 27% year to date, faster than product revenue, which grew 7% in each period. Management attributed the service growth to new subscriptions and renewals of FortiGuard and FortiCare contracts and described a continuing shift toward higher-margin recurring services. Service gross margin improved, while product gross margin declined: Q3 product margin was 57.6% versus 60.7% a year earlier; nine-month product margin was 58.0% versus 60.8%.
Operating expenses were $246.9m in Q3 and $730.8m year to date, up 9% in each comparison. Expenses declined as a share of revenue, helping operating income recover from the prior-year year-to-date loss. The nine-month 2016 comparison also included $3.2m of restructuring charges, versus $0.3m in 2017.
Cash, liquidity and balance sheet
- At September 30, 2017, cash and cash equivalents were $905.8m and investments were $617.8m, totaling $1.524bn, up $213.1m from December 31, 2016. Working capital was $740.0m.
- Deferred revenue was $1.219bn, up $183.6m, or 18%, from year-end 2016. Management identified subscription services as a principal contributor to operating cash generation.
- Nine-month operating cash flow was $436.9m, versus $244.7m in 2016. Investing activities used $142.1m, including $121.6m of property and equipment purchases; financing activities used $98.0m, primarily reflecting $124.0m of share repurchases.
- Q3 operating cash flow was $162.3m and non-GAAP free cash flow was $140.6m, compared with $76.1m and $70.2m, respectively, in Q3 2016.
- Total liabilities were $1.493bn, including $1.219bn of deferred revenue. The balance sheet presents no separate interest-bearing debt balance; the filing text does not provide a clear debt figure.
Changes, outlook and key risks
- Operating trends: Management said Q3 high-end products represented 41% of product billings, mid-range 29%, and entry-level 30%. All geographic regions grew; the Americas made the largest contribution to revenue growth.
- Management outlook: No specific revenue or earnings guidance is provided in the supplied filing text. Management expected research and development, sales and marketing, and general and administrative expenses to increase in absolute dollars during the remainder of 2017. It expected about $110m of 2017 real-estate capital expenditures, including the $84.8m Burnaby purchase, and approximately $120m of Sunnyvale headquarters build-out spending in 2018–2019. Management stated existing cash and cash equivalents should cover anticipated needs for at least 12 months.
- Capital returns: Fortinet repurchased 3.3m shares for $124.0m in the first nine months of 2017. In October, the board increased the repurchase authorization by $400m, bringing the aggregate authorization to $1.0bn through January 31, 2019.
- Customer and channel concentration: Exclusive Networks accounted for 29% of Q3 revenue and 31% of receivables at quarter-end; Ingram Micro represented 11% of Q3 revenue. The filing highlights dependence on distributors and quarter-end order concentration.
- Contingencies and tax: A U.S. Attorney’s Office inquiry into Trade Agreements Act compliance remained ongoing; Fortinet said it was cooperating. U.S. federal tax examinations for 2012–2014 and a French tax audit covering 2007–2015 were also disclosed. Management said no existing litigation claim was then believed likely to materially harm financial position, while noting outcomes remain uncertain.
- Accounting and unusual items: Fortinet planned to adopt the new revenue standard on January 1, 2018 using the modified retrospective method. It expected the revenue-recognition pattern to be substantially unchanged, but said capitalization and amortization of contract-acquisition commissions was likely to have a material financial-statement impact. The company also bought Burnaby real estate for $84.8m and reported $102.7m of stock-based compensation for the first nine months.
- Other risks: The filing emphasizes competition and pricing pressure, product defects or security failures, reliance on third-party manufacturers and limited component sources, foreign-exchange exposure, and possible variability in demand, billings and margins. It also notes that $773m of cash and investments were held by international subsidiaries and were not immediately available for domestic operations without repatriation.
Investor verification priorities
- Track service growth, deferred revenue and renewal trends against product growth, and assess whether recurring-service mix continues to support gross margins.
- Review distributor concentration, receivable exposure and channel inventory, particularly following Exclusive Networks’ acquisition of Fine Tec U.S.
- Monitor operating-expense growth, stock-based compensation and the conversion of operating cash flow into cash available after capital expenditures and repurchases.
- Confirm the realized impact of the 2018 revenue standard, especially commission-cost capitalization, and assess implementation readiness.
- Follow the Trade Agreements Act inquiry, tax examinations, and the scale and timing of real-estate spending and authorized buybacks.