Fortinet, Inc. — Q2 2012 Form 10-Q
Business context and period. Fortinet sells network-security appliances, software, subscriptions and support services. This unaudited filing covers the quarter and six months ended June 30, 2012; comparisons are with the corresponding 2011 periods.
Financial performance
- Q2 revenue: $129.0 million, up 25%. Product revenue was $61.7 million, up 32%; services revenue was $65.4 million, up 24%. Ratable and other revenue fell 49% to $1.9 million.
- Q2 profit and margins: Gross profit was $91.8 million; gross margin was 71.2%, versus 74.2%. Operating income rose 12% to $21.0 million, while operating margin declined to 16% from 18%. Net income was $14.0 million, down 4%; diluted EPS was $0.08 versus $0.09.
- First-half results: Revenue was $246.2 million, up 25%; operating income was $39.7 million versus $36.2 million; net income was $28.1 million, essentially flat. Diluted EPS was $0.17, unchanged.
- Cash flow: Q2 operating cash flow was $44.3 million versus $34.1 million; Q2 free cash flow, a non-GAAP measure, was $42.1 million versus $33.3 million. First-half operating cash flow was $92.8 million, up 25%.
- Liquidity and debt: Cash, cash equivalents and investments totaled $644.4 million at June 30, up from $538.7 million at year-end; working capital was $249.5 million. The balance sheet reports no debt balance; the filing text does not provide a separate debt figure. Management said available cash and operating cash flow should cover anticipated needs for at least 12 months. $21.5 million of cash was held by international subsidiaries.
- Deferred revenue and billings: Deferred revenue was $331.4 million, up $36.5 million from year-end. Q2 billings, defined by the company as revenue plus the change in deferred revenue, were $145.8 million, up from $110.2 million.
- Other metrics: The Q2 effective tax rate increased to 37% from 25%; the first-half rate was 33% versus 25%. Stock-based compensation was $7.9 million in Q2 and $15.1 million in the first half.
Changes versus prior period
- Revenue growth was broad across regions; first-half Americas, EMEA and APAC revenue rose 29%, 20% and 27%, respectively. Product growth was led by mid-range and higher-end appliances; services growth reflected a larger customer base and recognition of deferred subscription and support revenue.
- Gross margin weakened: Q2 product margin fell to 61.2% from 64.5%, and services margin to 80.9% from 83.7%. Management cited a large retail customer’s lower-margin product mix, higher component costs, investment in technical support, and growth in lower-margin consulting services.
- Operating expenses rose 23% in Q2, primarily from hiring and higher personnel and stock-compensation costs. Headcount increased to 1,762 from 1,475 a year earlier.
- One distributor, Exclusive Networks, accounted for 11% of Q2 revenue and 12% of first-half revenue; no customer exceeded 10% in the 2011 comparative periods.
Outlook, risks and unusual items
- No specific revenue or earnings guidance was provided. Management expected R&D expense as a share of revenue to remain comparable or decline, sales and marketing expense as a share of revenue to decline, and G&A expense as a share of revenue to remain comparable in the second half of 2012. Management’s current planning tax rate was 34%, subject to discrete items.
- Management attributed growth to product innovation, market-share gains and stronger enterprise and service-provider activity. It reported more large deals year over year, but cautioned that deal volumes can vary and said traction in U.S. federal government sales remained limited.
- Key risks include quarterly order and shipment timing, channel dependence, inventory and component availability, competition and pricing, product defects or security failures, service renewals, foreign-exchange exposure, and tax-rate variability. The filing notes that sales often concentrate near quarter-end.
- Open commitments included $26.9 million of non-cancelable manufacturer purchase orders and $21.7 million of operating-lease payments. Uncertain-tax-position liabilities, including interest, were $23.6 million; settlement timing could not be estimated.
- Pending matters included patent claims by ESR and NPS, a former-stockholder class action, and a dispute involving SRI International. Fortinet stated it did not believe a loss was reasonably possible at that time. The class action had summary-judgment motions scheduled for November 2012 and trial for December 2012.
- Fortinet acquired IntruGuard in March for $950,000, including $400,000 held in escrow; acquired technology is amortized over three years. After quarter-end, it purchased Sunnyvale property for $14.5 million as a future headquarters.
Investor verification priorities
- Assess whether revenue growth and deferred-revenue/billings growth persist, especially in subscription and support renewals.
- Track gross-margin recovery, including the effects of customer/product mix, component costs and support-service investment.
- Review dependence on Exclusive Networks and other channel partners, quarter-end sales concentration, and inventory and supply-chain commitments.
- Monitor the rising effective tax rate, uncertain tax positions and the implications of the expired U.S. federal research tax credit.
- Check subsequent developments in the disclosed litigation and the financial and operating effects of the IntruGuard acquisition and headquarters property purchase.