Fortinet, Inc. — FY 2016 Form 10-K
Reporting period: Fiscal year ended December 31, 2016. This is an annual report, not a standalone fourth-quarter filing; quarterly figures below are unaudited. Fortinet sells network-security hardware, software, subscriptions and support, primarily through channel partners.
Financial results and key metrics
| Metric | FY 2016 | FY 2015 |
|---|---|---|
| Revenue | $1.275 billion (+26%) | $1.009 billion |
| Product revenue | $548.1 million (+15%) | $476.8 million |
| Service revenue | $727.3 million (+37%) | $532.5 million |
| Gross profit / gross margin | $937.6 million / 73.5% | $722.5 million / 71.6% |
| Operating income / margin | $42.9 million / 3.4% | $14.9 million / 1.5% |
| Net income / diluted EPS | $32.2 million / $0.18 | $8.0 million / $0.05 |
| Operating cash flow | $345.7 million | $282.5 million |
| Free cash flow (non-GAAP) | $278.5 million | $245.2 million |
| Billings (non-GAAP) | $1.515 billion (+23%) | $1.232 billion |
| Deferred revenue | $1.035 billion (+31%) | $791.3 million |
At year-end, cash, cash equivalents and investments totaled $1.311 billion, working capital was $709.3 million, and total assets were $2.140 billion. The balance sheet does not identify a material interest-bearing debt balance as a separate line item. Total liabilities were $1.302 billion, including $1.035 billion of deferred revenue and $68.6 million of long-term income-tax liabilities.
For Q4 2016, revenue was $362.8 million, operating income was $45.2 million and net income was $25.2 million. Q4 operating income was substantially higher than in the preceding quarters.
Changes and management commentary
- Service revenue grew faster than product revenue, lifting services to 57% of revenue from 53%. Management attributed growth to a larger customer base, subscription and support renewals, enterprise bundles and the Fortinet Security Fabric.
- Gross margin rose 1.9 percentage points, with improvement in both product and service margins. Product margin benefited from software sales and lower warranty costs, partly offset by higher inventory reserves.
- Operating expenses rose $187.0 million (26%), led by a 33% increase in sales and marketing spending. Headcount increased 16% to 4,665 employees and contractors. Operating income improved, but investment spending remained substantial.
- The company generated $345.7 million of operating cash flow, supported in part by a $243.0 million increase in deferred revenue. Capital expenditures were $67.2 million; share repurchases used $110.8 million for 3.9 million shares.
- Fortinet acquired AccelOps in June 2016 for $22.1 million net cash consideration. It also repatriated $55.0 million of foreign cash during Q4, citing an associated $22.3 million foreign tax credit.
Outlook, risks and unusual items
- Management expected 2017 overall gross margin to remain relatively comparable to 2016; R&D expense as a percentage of revenue to remain relatively comparable; and sales and marketing expense as a percentage of revenue to decline. It expected G&A expense as a percentage of revenue to increase as ERP capabilities expanded and the new revenue standard was implemented.
- Management anticipated 2017 capital expenditures of approximately $140 million to $150 million, primarily for real estate and facilities. It stated existing cash and investments were sufficient for anticipated needs for at least the next 12 months. No specific revenue or earnings guidance is provided in the filing.
- Sales organization realignment took longer than expected to ramp, negatively affecting revenue growth in some regions in Q3. Billings are concentrated late in quarters: 37% of 2016 billings occurred in the final two weeks of each quarter.
- One distributor, Exclusive Networks, represented 20% of 2016 revenue, up from 18% in 2015; Exclusive and Fine Tec together represented 36% of year-end net accounts receivable. Fortinet also relies on channel partners and faces concentrated sources for certain components and outsourced manufacturing.
- In October 2016, the U.S. Attorney’s Office for the Northern District of California requested information about Trade Agreements Act compliance. The inquiry was ongoing; Fortinet said it was cooperating. The company also disclosed ongoing patent and other litigation, but did not record significant litigation loss accruals, stating a possible loss range could not be estimated.
- Early adoption of ASU 2016-09 affected reported earnings: approximately $10.8 million of excess stock-compensation tax benefits were recognized in the 2016 tax provision, and the effective tax rate fell to 25% from 53% in 2015. The filing also describes a material implementation effort for the revenue-recognition standard effective in 2018; timing of recognition and contract-cost treatment could change.
Most important facts for investors to verify
- Whether recurring service growth, deferred revenue growth and billings continue to translate into recognized revenue and operating cash flow.
- Whether sales and marketing investment produces durable growth and margin improvement, particularly after the slower sales-force ramp reported in 2016.
- The revenue and receivables exposure to Exclusive Networks, and the company’s ability to manage channel inventory and partner credit risk.
- The outcome and potential financial exposure, if any, from the Trade Agreements Act inquiry and ongoing litigation.
- The planned $140 million to $150 million 2017 capital spending, real-estate commitments and related liquidity effects; contractual obligations totaled $207.4 million at year-end, including $91.2 million of inventory purchase commitments.
- The effect of the 2016 tax-accounting changes and adoption of the new revenue standard on comparability of future earnings, cash flows and margins.