Fortinet, Inc. — Q3 2011 Form 10-Q
Business context and period. Fortinet provides network security appliances and related subscription, support and other services. This unaudited quarterly report covers the three and nine months ended September 30, 2011; comparisons are with the corresponding 2010 periods unless noted. Dollar figures below are in millions except per-share amounts.
Key financial metrics
| Metric | Q3 2011 | Q3 2010 | Nine months 2011 | Nine months 2010 |
|---|---|---|---|---|
| Revenue | $116.4 (+37.0%) | $85.0 | $312.7 (+35.3%) | $231.1 |
| Gross profit / margin | $85.3 / 73.3% | $63.5 / 74.8% | $231.6 / 74.1% | $170.1 / 73.6% |
| Operating income | $26.2 | $18.2 | $62.4 | $34.6 |
| Net income | $17.9 | $14.0 | $46.0 | $25.1 |
| Diluted EPS | $0.11 | $0.09 | $0.28 | $0.16 |
| Cash from operating activities | $36.0 | $32.2 | $110.3 | $72.0 |
| Free cash flow (non-GAAP) | $34.7 | $31.5 | Not clearly stated for the period in the MD&A table | Not clearly stated for the period in the MD&A table |
- Revenue mix, Q3: product $53.1 (+47.8%); services $57.8 (+29.9%); ratable and other $5.5 (+21.3%). Services were 49.7% of revenue. Revenue outside the Americas was 57.0%.
- Margins and costs: Q3 GAAP gross margin fell 1.5 percentage points year over year, mainly because product revenue grew faster than higher-margin services. Operating expenses rose 30.3%, slower than revenue growth.
- Liquidity: cash, cash equivalents and investments totaled $503.0 at September 30, versus $387.5 at December 31, 2010. Working capital was $252.3. Current assets were $503.9 and current liabilities $251.7. The balance sheet reports no debt balance.
- Deferred revenue: $275.1 at quarter-end, including $192.9 current and $82.2 non-current. Q3 billings, a company-defined non-GAAP measure (revenue plus the change in deferred revenue), were $118.4, up 25.0%.
Material changes versus prior periods
- For the first nine months, revenue rose 35.3%, operating income rose about 80%, and net income rose about 83% year over year.
- Product revenue growth outpaced services growth, increasing product’s share of Q3 revenue to 45.6% from 42.3%; services’ share declined to 49.7% from 52.4%.
- New revenue recognition standards adopted January 1, 2011 increased reported revenue by $5.1 in Q3 and $14.1 for the nine-month period, primarily by allowing some product revenue to be recognized upon shipment.
- A $2.6 sale of previously acquired patents contributed to Q3 ratable and other revenue and gross profit. Fortinet also acquired TalkSwitch for $2.6 cash in April 2011.
- Cash from operations improved year over year for the first nine months. Growth in deferred revenue and income taxes payable were significant sources of operating cash.
Outlook, management commentary, risks and unusual items
- Management expected near-term overall gross margin to remain comparable to, or decrease slightly from, the first three quarters of 2011. It expected R&D, sales and marketing, and G&A expenses to increase in absolute dollars, with sales and marketing remaining the largest operating expense.
- Management said existing cash, cash equivalents and investments, together with operating cash flow, should meet anticipated cash needs for at least 12 months. The filing provides no specific numerical revenue or earnings guidance.
- Fortinet reported shortages of specific products in Q3 as demand exceeded forecasts. It also disclosed $32.5 of open contract-manufacturer purchase orders that may not be cancelable, up from $18.3 at June 30; flooding in Thailand was extending lead times for some components.
- Trend Micro litigation concerns disputed royalty obligations. Fortinet had accrued $6.3, including interest, for unpaid amounts and continued to accrue contractual royalties; the company disputes its obligation. The PTO had rejected a number of relevant patent claims, but the dispute remained unresolved.
- Other pending matters include patent claims by Network Protection Sciences and a former-stockholder class action. The filing describes unspecified damages; management stated it did not consider losses reasonably possible for those matters at the time.
- Unrecognized tax benefits were approximately $17.2 at September 30, up from $11.2 at December 31, 2010; the timing of any related cash outflows was uncertain. The Q3 effective tax rate was 33.9%, versus 23.3% a year earlier; the nine-month rate was 28.9%.
- Additional principal risks include quarterly sales variability, channel-partner dependence, competition and pricing pressure, inventory and supplier concentration, product defects or security failures, foreign-exchange exposure, and intellectual-property disputes. Management reported disclosure controls were effective and no material Q3 change in internal control over financial reporting.
Important facts for investors to verify
- Reconcile the filing’s stated Q3 operating margin: the key-metrics table reports 22.0%, while operating income of $26.160 divided by revenue of $116.426 implies approximately 22.5%.
- Assess how much reported growth came from the new revenue-recognition rules and the one-time patent sale, and monitor future billings and deferred-revenue trends.
- Track product availability, component lead times, and whether the $32.5 of potentially noncancelable purchase commitments address shortages without creating excess inventory.
- Monitor the Trend Micro dispute, the $6.3 accrued amount and future royalty accruals, along with other litigation and tax uncertainties.
- Review the composition, credit quality and maturities of the $436.3 investment portfolio, and the sustainability of operating cash flow given its reliance on deferred revenue and tax-payment timing.