Fortinet, Inc. — Form 10-Q Summary
Reporting period: Quarter ended March 31, 2019. Financial comparisons are to the three months ended March 31, 2018 unless otherwise noted. Amounts are in U.S. dollars.
Business context
Fortinet sells cybersecurity products and services, including FortiGate network-security appliances, FortiGuard security subscriptions and FortiCare support. It reports one operating segment and sells primarily through distributors and other channel partners.
Key financial metrics
| Metric | Q1 2019 | Q1 2018 / comparison |
|---|---|---|
| Product revenue | $162.7 million | $142.8 million; up 14% |
| Service revenue | $309.9 million | $256.2 million; up 21% |
| Total revenue | $472.6 million | $399.0 million; up 18% |
| Gross profit / margin | $359.6 million / 76.1% | $301.8 million / 75.6% |
| Operating income / margin | $50.6 million / 10.7% | $32.4 million / 8.1% |
| Net income / diluted EPS | $58.8 million / $0.34 | $41.6 million / $0.24 |
| Operating cash flow | $201.3 million | $139.7 million |
| Free cash flow (non-GAAP) | $191.1 million | $128.1 million |
| Billings (non-GAAP) | $551.6 million | $463.2 million; up 19% |
Product gross margin fell to 56.9% from 59.2%; service gross margin rose to 86.2% from 84.8%. Total gross margin improved by 0.5 percentage points, supported by the higher service-revenue mix. Operating expenses were $309.0 million, up 15%, but declined to 65% of revenue from 68%.
At March 31, 2019, cash and cash equivalents were $1.217 billion and investments were $635.1 million, totaling $1.852 billion. Working capital was $1.059 billion. Deferred revenue was $1.766 billion, up $79.0 million from year-end and 26% above the comparable prior-year level. The filing presents no borrowings in the balance sheet; total liabilities were $2.148 billion, including deferred revenue and lease liabilities.
Cash increased by $104.5 million during the quarter. Investing activities used $39.0 million, including $10.2 million of property and equipment purchases; financing activities used $57.8 million, primarily for share repurchases and taxes on net-settled equity awards.
Material changes and drivers
- Service revenue growth was driven by security subscriptions and technical support, including revenue recognized from prior-period contracts. FortiGuard and other security subscription revenue grew 24%; FortiCare and other service revenue grew 17%.
- Management reported higher FortiGate unit shipments and growth in non-FortiGate, Security Fabric and cloud products. Revenue grew across regions: Americas 14%, EMEA 23% and APAC 21%.
- Research and development expense rose 16% and sales and marketing expense rose 17%, mainly reflecting personnel costs and investment in product development and global sales capacity.
- Interest income increased to $10.2 million from $4.5 million, primarily due to higher rates and invested balances. The effective tax rate was 2%, versus a 13% tax benefit in Q1 2018; the prior-year period included a $7.8 million benefit from release of uncertain-tax-position reserves.
- Fortinet repurchased 0.8 million shares for $56.2 million at an average $72.19 per share. $677.5 million remained available under the repurchase authorization.
Outlook, risks and unusual items
- No specific revenue or earnings guidance is provided in the filing. Management expects research and development, sales and marketing, and general and administrative expenses to increase in absolute dollars during the remainder of 2019.
- Management estimated $60 million to $80 million of 2019 spending on construction of its new headquarters building. It stated existing cash and cash equivalents should meet anticipated needs for at least 12 months.
- Adoption of lease accounting on January 1, 2019 added operating-lease right-of-use assets of $39.1 million and lease liabilities of $40.6 million at adoption, with no material impact on income or cash flows. At quarter-end, operating lease liabilities totaled $39.4 million.
- Open inventory purchase commitments were $202.2 million, most due in 2019; other non-cancelable commitments with remaining terms over one year were $15.8 million. These commitments expose the company to demand-forecast and inventory risks.
- Distributor concentration is material: Exclusive Networks represented 30% of quarterly revenue and 34% of net receivables; Ingram Micro represented 11% of revenue and 10% of net receivables.
- The filing highlights risks from competition, channel-partner dependence, product and component supply constraints, quarter-end shipment concentration, international operations, cybersecurity vulnerabilities, tariffs and macroeconomic uncertainty. It identifies ongoing patent litigation, including cases filed by British Telecommunications and Finjan. Management said it was unaware of existing claims likely to materially harm financial position, but litigation outcomes remain uncertain.
- Unrecognized tax benefits were $65.9 million; ongoing foreign tax audits focus on intercompany profit allocation. The filing says up to $10 million of gross unrecognized benefits could decrease within 12 months as statutes of limitation lapse.
- Management concluded disclosure controls were effective as of March 31, 2019. The filing also says the prior Trade Agreements Act inquiry was settled.
Most important facts for investors to verify
- Whether service growth, deferred revenue and billings continue to translate into recognized revenue and cash flow; billings and free cash flow are non-GAAP measures defined by the company.
- Whether service-led margin improvement persists while product gross margin remains under pressure.
- Whether distributor concentration, particularly Exclusive Networks, and the $202.2 million of inventory commitments create collection, demand or inventory risks.
- Actual headquarters construction spending and the effect of repurchases, equity compensation and related tax withholding on cash and share count.
- Developments in patent litigation, foreign tax audits and other contingencies, and any effects of supply constraints, tariffs or cybersecurity incidents.