Fortinet, Inc. — Q1 2016 Form 10-Q
Reporting period: Three months ended March 31, 2016; comparisons are with the three months ended March 31, 2015 unless stated otherwise. Fortinet provides cybersecurity products and subscription and support services. Results are unaudited.
Financial performance and liquidity
| Metric | Q1 2016 | Prior-year period / comparison |
|---|---|---|
| Revenue | $284.6 million | $212.9 million; up 34% |
| Product revenue | $124.6 million | $97.5 million; up 28% |
| Service revenue | $160.0 million | $115.4 million; up 39% |
| Gross profit / gross margin | $206.8 million / 72.7% | $149.3 million / 70.1% |
| Operating expenses | $212.5 million | $148.4 million; up 43% |
| Operating income (loss) | $(5.7) million | $0.9 million |
| Net income (loss) / diluted EPS | $(3.4) million / $(0.02) | $1.6 million / $0.01 |
| Cash provided by operations | $100.6 million | $64.6 million |
| Capital expenditures / free cash flow | $30.0 million / $70.6 million | $4.9 million / $59.7 million |
| Cash, cash equivalents and investments | $1.194 billion | $1.164 billion at December 31, 2015 |
| Deferred revenue | $837.2 million | $791.3 million at December 31, 2015 |
| Working capital | $598.4 million | $591.9 million at December 31, 2015 |
Total gross margin improved by 2.6 percentage points. Product and service gross margins were 60.4% and 82.3%, respectively. The company reported no debt balance on the presented balance sheet. It held $419.7 million of cash and investments at international subsidiaries, which were not immediately available for domestic operations without repatriation and potential U.S. tax.
Cash and cash equivalents increased $24.7 million during the quarter. Investing activities used $34.2 million, primarily reflecting capital spending; financing activities used $41.7 million, including $50.0 million of share repurchases. Billings, a company-defined non-GAAP measure, were $330.5 million, up from $254.3 million.
Material changes and management commentary
- Revenue increased across all geographic regions; EMEA had the largest year-over-year increase in both dollars and percentage terms. High-end FortiGate products represented 37% of billings, mid-range products 28%, and entry-level products 35%.
- Operating expenses rose substantially as Fortinet expanded sales, marketing, research and development, and customer support. Headcount increased 38% year over year to 4,239 employees and contractors. Sales and marketing expense rose 47%; research and development rose 26%.
- Management attributed revenue growth to demand across FortiGate product categories and growth in subscription and support services. Service revenue also reflects recognition over time of previously contracted services, typically over one to three years.
- Stock-based compensation was $30.9 million, compared with $18.9 million in the prior-year period, an important contributor to reported expenses.
- Fortinet repurchased 2.0 million shares for $50.0 million under a $200.0 million program authorized through December 31, 2017; $150.0 million remained available at quarter-end.
- Cash capital expenditures were $30.0 million, including $18.5 million for real property in Union City, California. Property and equipment purchases were notably higher than in the prior-year quarter.
Outlook, risks and contingencies
- Management expected research and development expense as a percentage of revenue to remain relatively comparable during the remainder of 2016; sales and marketing expense as a percentage of revenue to decrease slightly; and general and administrative expense as a percentage of revenue to remain relatively comparable. These are directional expectations, not revenue or earnings guidance.
- Fortinet expected 2016 capital expenditures of $50 million to $60 million, primarily for office expansion and ERP implementation. Management believed existing cash and cash equivalents would cover anticipated needs for at least 12 months.
- The Meru-related restructuring program was estimated at $8.0 million to $8.5 million in total charges; $7.9 million had been incurred through March 31, 2016. Remaining cash payments were expected through 2017.
- Key disclosed risks include quarterly results variability and quarter-end shipment concentration; reliance on distributors and resellers; customer and distributor concentration; competition and pricing pressure; supply and manufacturing constraints; product vulnerabilities or failures; foreign currency exposure; and execution risks in scaling operations and implementing the new ERP system. Exclusive Networks Group accounted for 19% of quarterly revenue.
- The company disclosed ongoing litigation and intellectual-property disputes but said it had not recorded a significant litigation loss accrual and could not estimate a possible loss range. Management did not believe current claims were likely to materially affect financial position, while noting outcomes remained uncertain.
- Unrecognized tax benefits were $63.4 million at quarter-end, with $6.7 million accrued for estimated interest on uncertain tax positions. Fortinet was under U.S. federal tax examination for 2012–2014 and did not expect a significant decrease in uncertain tax benefits within 12 months.
- Management reported disclosure controls and procedures were effective as of March 31, 2016, and stated there had been no material change in internal control over financial reporting during the quarter.
Important facts for investors to verify
- Whether billings and deferred-revenue growth continue to translate into recognized service revenue and sustainable cash generation.
- Whether substantial hiring and sales-and-marketing investment produce growth sufficient to offset expense increases; Q1 recorded an operating loss despite strong revenue growth.
- The persistence of gross-margin improvement, including the product mix and inventory-efficiency effects cited by management.
- Capital-spending trajectory, ERP implementation costs and execution, and remaining Meru restructuring charges and payments.
- Distributor concentration, channel inventory and quarter-end shipment exposure, together with any developments in litigation, tax examinations, supply constraints or product-security issues.