Fortinet, Inc. — Q2 2021 Form 10-Q
Reporting period: Three and six months ended June 30, 2021. Unaudited results; amounts are in U.S. dollars. Comparatives for 2020 were revised for an immaterial revenue-recognition correction described below.
Business context and results
Fortinet sells cybersecurity products and services, including FortiGate network security products, security subscriptions and technical support. Management reports one operating segment. Revenue grew across products, services and all regions; management attributed growth to demand across the Security Fabric portfolio and the elevated cyber threat environment.
| Metric | Q2 2021 | Q2 2020 | Six months 2021 | Six months 2020 |
|---|---|---|---|---|
| Revenue | $801.1m | $617.6m | $1,511.4m | $1,195.3m |
| Product revenue | $298.3m | $211.9m | $539.0m | $404.2m |
| Service revenue | $502.8m | $405.7m | $972.4m | $791.1m |
| Gross profit | $614.2m | $482.5m | $1,167.9m | $931.5m |
| Operating income | $147.5m | $118.8m | $269.1m | $235.5m |
| Net income | $137.5m | $113.8m | $244.7m | $218.4m |
| Diluted EPS | $0.82 | $0.69 | $1.47 | $1.29 |
Financial position, cash flow and liquidity
- Margins: Q2 gross margin was 76.7%, down from 78.1%; operating margin was approximately 18%, versus 19%. For the first half, gross margin was 77.3%, versus 77.9%, and operating margin was approximately 18%, versus 20%. Product mix shifted toward lower-margin products; service margin also faced foreign-exchange and data-center cost pressure.
- Cash flow: First-half operating cash flow was $734.1m, compared with $566.4m. Q2 operating cash flow was $418.2m, compared with $247.0m. First-half capital expenditures were $75.6m. Q2 non-GAAP free cash flow was $394.7m, versus $216.1m; the filing defines this measure as operating cash flow less property and equipment purchases, excluding significant nonrecurring items.
- Cash and liquidity: Cash and equivalents were $1,879.3m; investments totaled $1,480.5m; combined cash, equivalents and investments were $3,359.8m. Working capital was $1,909.7m. Management said available cash and operating cash flow should meet anticipated needs, including for at least the next 12 months.
- Debt: Long-term debt, net of discount and issuance costs, was $987.5m. Fortinet issued $1.0bn of senior unsecured notes in March: $500m at 1.0% due 2026 and $500m at 2.2% due 2031. The debt note states there are no financial covenants.
- Deferred revenue and obligations: Deferred revenue was $2,905.4m, up 12% from year-end. Remaining performance obligations were $2.91bn; approximately $1.53bn was expected to be recognized over the next 12 months.
Material changes versus the prior comparable period
- Q2 revenue increased 30%; product revenue rose 41% and service revenue 24%. First-half revenue increased 26%, with product revenue up 33% and service revenue up 23%.
- Q2 net income increased about 21%; first-half net income increased about 12%. First-half operating income grew 14%, partly affected by a much smaller IP-related gain than in 2020.
- First-half interest income declined to $2.3m from $13.2m, which management attributed primarily to lower rates. Interest expense was $5.8m, reflecting the newly issued notes.
- First-half investing cash flow was a $751.7m use, including net investment purchases, capital spending, a $75m Linksys investment and the ShieldX acquisition. Financing cash flow was $835.1m provided, principally reflecting note proceeds.
- The 2020 comparison was corrected for the timing of revenue recognition on certain FortiCare contracts. The correction increased 2020 service revenue by $2.1m for Q2 and $2.9m for the first half, and net income by $1.7m and $2.3m, respectively. Fortinet deemed it immaterial and said it did not change previously disclosed trends or affect operating cash flow, billings or free cash flow.
Outlook, commentary, risks and unusual items
- Outlook: The filing does not provide specific revenue or earnings guidance. Management expected R&D, sales and marketing, and general and administrative expenses to increase in absolute dollars during the remainder of 2021. Full-year capital expenditures were estimated at $175m–$200m; approximately $30m of remaining headquarters-building payments were expected in the second half.
- Demand and pandemic: Management reported strong product and service demand but emphasized that COVID-19 effects, sales cycles, customer spending and return-to-office conditions remained uncertain. It also noted longer average service-contract duration in Q2 year over year.
- Supply chain: Global chip and component shortages, manufacturing capacity and shipping constraints could limit product availability, delay revenue or raise costs. Fortinet increased on-hand stock to mitigate risk. At June 30, it had $628.7m of inventory purchase commitments, including orders that may not be cancellable.
- Customer and channel concentration: Exclusive Networks represented 31% of Q2 revenue and 32% of net receivables at quarter-end. Ingram Micro represented 12% of Q2 revenue and 13% of receivables. Fortinet relies substantially on channel partners and identifies distributor credit and concentration as risks.
- IP-related item: A mutual covenant-not-to-sue agreement generated a $1.2m Q2 gain and $2.3m first-half gain in 2021. The comparable first half of 2020 included a $36.0m upfront gain plus $1.9m of amortization, making reported year-over-year operating income comparisons less representative of underlying trends.
- Investments and acquisitions: Fortinet invested $75m for 32.6% of Linksys in March and acquired ShieldX assets for $10.8m. After quarter-end, it agreed, subject to closing conditions, to invest another $85m in Linksys; expected ownership after closing was 50.8%. Accounting impact was still under evaluation.
- Legal and tax matters: Litigation accruals were not material, and management said it was unaware of claims likely to materially harm financial position, while cautioning that outcomes are uncertain and IP litigation could affect future margins. Unrecognized tax benefits were $79.9m; ongoing foreign tax audits focus on intercompany profit allocation.
Most important facts for investors to verify
- Whether revenue, billings and deferred-revenue growth continue, and how much growth reflects product demand versus service-contract timing and duration.
- Whether gross and operating margins stabilize amid product-mix shifts, service costs, component shortages and rising operating expenses.
- Whether Fortinet can meet demand without excess inventory, given supply constraints and $628.7m of purchase commitments that may be non-cancellable.
- Exposure to key distributors, particularly Exclusive Networks, and their ability to pay and sustain sales volumes.
- Closing, funding and accounting treatment of the additional Linksys investment, and the cash and operating implications of expected capital spending and debt service.
- The effects of the prior-period revenue correction, IP-related gains, tax benefits and stock-based compensation on reported comparability and earnings quality.