Fortinet, Inc. — Q1 2013 Form 10-Q
Reporting period: Three months ended March 31, 2013; comparative period is Q1 2012. Fortinet sells network-security appliances and related subscription, support, and other services through channel partners. Figures below are in U.S. dollars; financial amounts are in millions unless stated otherwise.
Financial performance and position
| Metric | Q1 2013 | Q1 2012 / prior date | Change |
|---|---|---|---|
| Revenue | $135.8 | $117.2 | +16% |
| Product revenue | $58.0 | $53.2 | +9% |
| Services revenue | $75.9 | $62.1 | +22% |
| Gross profit / margin | $96.7 / 71.2% | $86.2 / 73.5% | Margin down 2.3 percentage points |
| Operating income / margin | $15.4 / 11% | $18.7 / 16% | Income down 18% |
| Net income | $12.2 | $14.2 | Down 14% |
| Diluted EPS | $0.07 | $0.09 | Down $0.02 |
| Operating cash flow | $38.1 | $48.5 | Down 21% |
| Free cash flow (company-defined, non-GAAP) | $36.6 | $46.9 | Down 22% |
| Deferred revenue | $376.4 at March 31 | $363.2 at December 31 | Up $13.2 |
Operating expenses rose 20% to $81.3 million, with increased hiring and investment in research and development and sales and marketing. Product gross margin declined to 60.4% from 64.2%, and services gross margin to 79.5% from 82.0%. Management attributed the declines to product mix and overhead, investment in technical support, and growth in lower-margin consulting services.
Cash, cash equivalents, and investments totaled $782.5 million at quarter-end, versus $739.6 million at December 31, 2012; working capital was $281.9 million. Cash and cash equivalents alone were $97.4 million. The balance sheet reports no debt balance. Operating cash flow was supported by deferred-revenue growth and collections, partly offset by increased other assets and inventory. Investing cash outflow was $79.2 million, mainly net investment purchases, plus the Coyote Point acquisition and capital expenditures. The company said available cash and investments should cover anticipated needs for at least 12 months; $50.7 million of cash was held by international subsidiaries and was not immediately available for domestic operations without repatriation.
Billings, a company-defined non-GAAP measure, were $148.5 million versus $137.0 million. One distributor accounted for 12% of revenue, compared with 11% in Q1 2012.
Material changes and management commentary
Revenue growth was led by services, reflecting recognition of subscription and support contracts sold to a growing customer base. Revenue increased across all reported regions: Americas +13%, EMEA +16%, and APAC +20%. However, management cited macroeconomic and geopolitical challenges in Latin America and EMEA and weaker-than-expected U.S. service-provider sales, including fewer large deals. Deals above $500,000 fell to 13 from 19, while deals above $250,000 rose to 55 from 47 and deals above $100,000 rose to 170 from 153.
Headcount increased to 2,077 from 1,655 a year earlier. Management said it planned continued investment in product development and sales coverage, and expected R&D, sales and marketing, and general and administrative expense as percentages of revenue to remain at approximately comparable levels for the rest of fiscal 2013. The filing provides no specific revenue or earnings guidance.
Outlook, risks, contingencies, and unusual items
- Acquisition: Fortinet acquired Coyote Point Systems on March 21 for approximately $6.0 million in cash. Up to $5.5 million of additional earn-out payments may be due, subject to performance and service conditions; the company expects qualifying payments to be recorded as compensation expense.
- Supply and inventory: Fortinet reported shortages and long lead times for certain components and inventory shortages for some products. It had $36.6 million of potentially non-cancellable contract-manufacturer purchase orders and $9.2 million of other purchase commitments.
- Commitments: A Canadian facility lease was extended through 2020, adding $14.3 million of lease payments. Total disclosed operating-lease payments were $28.6 million.
- Litigation: Three patent matters were disclosed: ESR’s appeal remains pending; the NPS case was scheduled for a September 2013 jury trial; and Fortinet’s declaratory-relief case against SRI was in early stages. Management stated it did not believe the matters would have a material adverse effect and, in the notes, said it did not consider a loss reasonably possible at that time.
- Taxes: The effective tax rate was 28%. Unrecognized tax benefits were $30.2 million; the filing also disclosed $32.1 million of long-term tax liabilities, including interest, for uncertain tax positions. California was auditing 2010 and 2011 returns; Fortinet did not expect a material adverse impact from that audit.
- Other risks: Results may fluctuate with large customer orders, channel-partner performance, service renewals, competition and pricing, international conditions, and component availability. The company also highlighted security-product defects or vulnerabilities, foreign-exchange exposure, and reliance on third-party manufacturers. It reported effective disclosure controls as of March 31, 2013.
Important facts for investors to verify
- Whether deferred-revenue and billings growth translates into sustained future revenue and cash generation.
- Whether margins stabilize after the year-over-year declines, particularly as product mix, support investment, and consulting services evolve.
- Whether weaker U.S. service-provider demand and challenging Latin America and EMEA conditions persist, and whether large-deal activity recovers.
- Whether component shortages, inventory levels, and purchase commitments affect shipments, sales, or gross margin.
- The outcomes and potential costs of the disclosed patent cases, tax uncertainties, and Coyote Point earn-out obligations.
- The quality of reported earnings relative to recurring stock-based compensation of $9.3 million in the quarter and the company’s non-GAAP adjustments.