Fortinet, Inc. — Q1 2020 Form 10-Q
Reporting period: Three months ended March 31, 2020; unaudited. Comparisons are with Q1 2019 unless otherwise stated. Amounts are in U.S. dollars.
Business context
Fortinet sells cybersecurity hardware, software and services, primarily through channel partners. Its services include FortiGuard security subscriptions and FortiCare technical support. Service revenue represented 67% of Q1 revenue. The company reported one operating and reportable segment.
Financial performance
| Metric | Q1 2020 | Q1 2019 | Change |
|---|---|---|---|
| Product revenue | $192.3 million | $162.7 million | +18% |
| Service revenue | $384.6 million | $309.9 million | +24% |
| Total revenue | $576.9 million | $472.6 million | +22% |
| Gross profit | $448.2 million | $359.6 million | +25% |
| Gross margin | 77.7% | 76.1% | +1.6 percentage points |
| Operating income | $115.9 million | $50.6 million | +129% |
| Net income | $104.0 million | $58.8 million | +77% |
| Diluted EPS | $0.60 | $0.34 | — |
| Operating cash flow | $319.4 million | $201.3 million | +59% |
| Free cash flow, non-GAAP | $241.8 million | $191.1 million | +27% |
Product gross margin rose to 60.3% from 56.9%; service gross margin was 86.4% versus 86.2%. Free cash flow is defined by Fortinet as operating cash flow less capital expenditures and the $50 million IP-agreement proceeds.
Liquidity, cash flow and capital allocation
- Cash, cash equivalents and investments totaled $1.573 billion at March 31, down $636.6 million, or 29%, from year-end 2019. Cash and equivalents were $626.1 million; investments were $947.2 million.
- Working capital was $492.3 million, versus $1.295 billion at December 31, 2019. Current assets were $2.035 billion and current liabilities were $1.543 billion.
- Operating cash flow of $319.4 million included the $50 million receipt under the IP agreement. Investing activities provided $4.6 million; financing activities used $920.4 million, primarily for share repurchases.
- Fortinet repurchased 10.0 million shares for $899.9 million, an average $90.36 per share. $692.9 million remained authorized. After quarter-end through the filing date, it repurchased another 1.5 million shares for $146.1 million.
- The presented balance sheet does not show a borrowing or debt line; the filing text does not provide a clear debt balance. Fortinet said existing cash and cash equivalents should cover anticipated needs for at least 12 months.
Material changes and unusual items
- Operating income included a $36.8 million gain from a patent covenant-not-to-sue agreement with a competitor. Fortinet received $50 million in February. The agreement provides for a possible additional $50 million after seven years if extended; the company recognizes the remaining allocated consideration over the contract term.
- Excluding the IP gain, operating expenses as a share of revenue decreased by one percentage point year over year. Operating margin was 20%, compared with 11%, with the reported increase driven in part by the IP gain and improved gross margin.
- Other expense included a $4.3 million non-cash impairment of an investment in a privately held company and higher foreign-exchange losses. The effective tax rate rose to 11% from 2%.
- Deferred revenue was $2.227 billion at March 31, up $90.9 million, or 4%, from year-end. Remaining performance obligations were $2.23 billion; Fortinet expected approximately $1.23 billion to be recognized over the following 12 months.
Outlook, management commentary and risks
- Fortinet did not provide specific numerical revenue or earnings guidance in the supplied filing text. It expected research and development, sales and marketing, and general and administrative expenses to remain at or increase in absolute dollars during the rest of 2020.
- Management said Q1 had elevated buying in the middle two weeks of March, while service-contract terms, product backlog and channel inventory were consistent with historical patterns. Suppliers delivered more than 90% of commitments; average customer payment terms increased by less than 15%. Fortinet had not seen a material Q1 impact from COVID-19, but warned that the pandemic and downturn could materially harm future results, including Q2 and full-year 2020.
- COVID-19 risks include weaker customer demand or delayed decisions, extended sales cycles, supply-chain and shipping disruption, component shortages, higher costs and reduced ability to execute sales. Fortinet restricted travel and had most employees work remotely; mitigation costs to date were not material.
- Distributor concentration is significant: Exclusive Networks represented 31% of Q1 revenue and 34% of net accounts receivable at March 31. Ingram Micro represented 10% of Q1 revenue. Fortinet highlighted related collection and partner-credit risks.
- Inventory purchase commitments that may not be cancelable totaled $247.2 million, all scheduled for 2020. The company estimated $110–$120 million of 2020 spending on its headquarters expansion; construction was delayed, with completion then expected in early 2021.
- Risks also include operating-result variability and quarter-end sales concentration, competition and pricing pressure, dependence on third-party manufacturers and limited-source components, cybersecurity threats, litigation and IP claims, foreign-exchange exposure, and tax audits. Ongoing foreign tax audits focus on intercompany profit allocation; the Altera tax matter remained uncertain.
Most important facts for investors to verify
- How much of reported operating-income growth and cash generation is attributable to the one-time IP agreement, and how recurring results compare after that item.
- Whether revenue, billings and deferred-revenue growth continue as COVID-19 effects on demand, sales timing and supply chains develop.
- Cash and liquidity after substantial repurchases, the remaining buyback authorization, and planned headquarters and inventory commitments.
- Exposure to Exclusive Networks and other channel partners, including their ability to pay receivables and maintain orders.
- Potential effects of litigation, tax audits and the Altera matter on future expenses, cash flows and tax rates.