Fortinet, Inc. — Q1 2017 Form 10-Q
Business context and period. Fortinet provides cybersecurity hardware, software, subscriptions and support services. This unaudited quarterly filing covers the three months ended March 31, 2017; comparisons are with Q1 2016 unless otherwise noted.
Financial performance and liquidity
| Metric | Q1 2017 | Q1 2016 / comparison |
|---|---|---|
| Revenue | $340.6 million | $284.6 million; up 20% |
| Product revenue | $135.3 million | $124.6 million; up 9% |
| Service revenue | $205.3 million | $160.0 million; up 28% |
| Gross profit / gross margin | $250.0 million / 73.4% | $206.9 million / 72.7% |
| Operating income (loss) | $5.4 million; 1.6% margin | $(3.7) million; approximately (1.3)% margin |
| Net income | $10.7 million; diluted EPS $0.06 | $2.1 million; diluted EPS $0.01 |
| Operating cash flow | $129.7 million | $100.6 million |
| Capital expenditures / free cash flow (non-GAAP) | $13.5 million / $116.2 million | $30.0 million / $70.6 million |
- Revenue mix shifted toward services: services were 60% of revenue versus 56% a year earlier. Product gross margin declined to 59.1% from 60.4%, primarily due to higher inventory reserves and other charges; service gross margin improved to 82.8% from 82.3%.
- Net income included a $2.6 million income-tax benefit on $8.1 million of pretax income; the reported effective tax rate was a benefit of 32%, affected by $5.5 million of excess tax benefits on stock options.
- Cash, cash equivalents and investments totaled $1.441 billion at March 31, up from $1.311 billion at December 31, 2016. Working capital was $759.5 million. The company reported no debt line item in the balance sheet; the supplied filing text does not quantify borrowings separately.
- Deferred revenue was $1.098 billion, up $62.7 million, or 6%, from year-end 2016 and 31% year over year. Billings, a company-defined non-GAAP measure, were $403.3 million, up from $330.5 million.
- Cash flow from investing was $(31.3) million and financing was $15.8 million. No shares were repurchased in Q1; $189.2 million remained authorized under the repurchase program.
Material changes and management commentary
- Management attributed growth to FortiGate product sales, enterprise bundles, subscription renewals and a larger customer base. High-end products represented 36% of billings, mid-range 31% and entry-level 33%.
- Revenue grew in all regions: Americas 22%, EMEA 20% and APAC 15%. The Americas supplied the largest portion of growth.
- Operating expenses rose 16% to $244.6 million, mainly from investment in sales and marketing, product development and customer support. Headcount was 4,711, compared with 4,665 at year-end.
- Management expected R&D expense as a percentage of revenue to remain relatively comparable for the rest of 2017, sales and marketing expense as a percentage of revenue to decline, and G&A expense as a percentage of revenue to increase as the company prepared for the new revenue-recognition standard. It expected free cash flow to improve in the second half of 2017.
Outlook, risks and unusual items
- In April 2017, Fortinet bought approximately 282,000 square feet of Vancouver real estate for about $85 million; management said this would affect Q2 free cash flow. It also disclosed an Ottawa office-building purchase in March and was considering a significant Sunnyvale headquarters expansion, with future capital spending and potential impairment or depreciation risks.
- Management said existing cash and cash equivalents should cover anticipated needs for at least 12 months. However, $599.5 million of cash and investments were held by international subsidiaries and were not immediately available for domestic use; repatriation could trigger U.S. tax.
- The company identified substantial operating variability risks, including dependence on channel partners and distributors, quarter-end order concentration, competition and pricing pressure, inventory and component supply constraints, international exposure, and the possibility of product defects or security failures. Two distributors accounted for 20% and 12% of Q1 revenue, respectively.
- An inquiry by the U.S. Attorney’s Office for the Northern District of California regarding Trade Agreements Act compliance remained ongoing; Fortinet said it was cooperating. The filing also disclosed ongoing litigation and tax examinations, including a French audit opened after quarter-end for tax years 2007–2015. Management said no existing litigation was then believed likely to materially adversely affect financial position, while noting outcomes remained uncertain.
- ASU 2014-09, the new revenue-recognition standard, was scheduled to take effect January 1, 2018. Fortinet was assessing possible timing changes to revenue and related costs, including sales to certain channel partners, and expected to complete its assessment and select a transition method in the next two quarters of 2017. The company estimated lease assets and liabilities recognized under the new lease standard could be at least $50 million.
- Disclosure controls were deemed effective as of March 31, 2017, and no material change in internal control over financial reporting was reported during the quarter.
Investor verification points
- Track service renewals, deferred revenue and billings alongside recognized revenue to assess underlying demand and future revenue conversion.
- Assess whether service-led growth and improved total gross margin can offset product-margin pressure and continued operating investment.
- Review the effects of the $85 million Vancouver purchase and other property plans on cash flow, capital needs and potential future impairments.
- Monitor distributor concentration, channel inventory and supply availability, particularly given quarter-end order concentration and non-cancelable purchase commitments.
- Follow developments in the Trade Agreements Act inquiry, litigation and tax audits, and Fortinet’s quantified adoption impact and transition approach for the new revenue standard.