Fortinet, Inc. — FY 2018 Form 10-K
Business context and reporting period. Fortinet provides cybersecurity products and services, led by FortiGate network-security appliances and recurring FortiGuard subscription and FortiCare support services. This annual report covers the fiscal year ended December 31, 2018; quarterly figures below refer to the three months ended December 31, 2018. The company reported one operating segment.
Financial results and position
| Metric | FY 2018 | FY 2017 | Change |
|---|---|---|---|
| Revenue | $1,801.2 million | $1,494.9 million | +20% |
| Product revenue | $674.4 million | $577.2 million | +17% |
| Service revenue | $1,126.8 million | $917.7 million | +23% |
| Gross profit / gross margin | $1,350.8 million / 75.0% | $1,109.6 million / 74.2% | Margin +0.8 percentage points |
| Operating income / margin | $231.0 million / 13% | $109.8 million / 7% | Income +110% |
| Net income | $332.2 million | $31.4 million | Basic EPS: $1.96 vs. $0.18 |
| Cash from operating activities | $638.9 million | $594.4 million | +7% |
| Free cash flow (non-GAAP) | $585.9 million | $459.1 million | +28% |
Service revenue was 63% of revenue and carried an 85.9% gross margin, compared with 56.9% for product revenue. Cash, cash equivalents and investments totaled $1,716.6 million at year-end; working capital was $964.5 million. Deferred revenue was $1,686.8 million, up 26%, and non-GAAP billings were $2,153.3 million, up 20%. The balance sheet reports no borrowings or debt balance; liabilities were principally deferred revenue and other operating liabilities.
In Q4 2018, revenue was $507.0 million, operating income was $85.1 million and net income was $182.6 million. Q4 2017 revenue was $416.6 million and net loss was $29.0 million.
Material changes versus the prior period
- Revenue growth accelerated across both product and service categories; management cited higher FortiGate shipments and growth in Security Fabric, cloud and recurring services. EMEA recorded the largest regional contribution to 2018 revenue growth.
- Operating margin improved to 13% from 7%, supported by revenue growth, gross-margin expansion and lower operating expenses as a share of revenue. Reported 2018 sales and marketing expense benefited by $45.5 million from the new revenue standard’s capitalization of certain service-contract commissions.
- Fortinet adopted Topic 606 on January 1, 2018 using the modified retrospective method. Adoption increased reported 2018 revenue by $19.4 million, operating income by $63.5 million and net income by $52.6 million versus the company’s presentation of 2018 results without adoption. The opening accumulated-deficit adjustment was $117.3 million.
- Net income also reflects a substantial tax benefit: the 2018 income-tax benefit was $81.3 million, including a $164.0 million benefit from tax-structure realignment/book-to-tax basis differences. This makes reported net income and the comparison with 2017—whose tax expense included Tax Act effects—less representative of underlying operating growth.
- Cash and investments rose 27%. The company repurchased 3.8 million shares for $209.1 million during 2018; $733.8 million remained authorized at year-end.
Outlook, management commentary, risks and contingencies
- No specific numerical revenue or earnings guidance is provided in the supplied filing text. Management expects 2019 gross margin to be comparable to 2018 and expects research and development, sales and marketing, and general and administrative expenses to increase in absolute dollars. It plans continued investment in enterprise sales, marketing and product development.
- Construction began on a new Sunnyvale headquarters building in Q4 2018; expected 2019 project spending is $60–$80 million. Management says existing cash and investments should meet anticipated needs for at least the next 12 months.
- Key business risks include intense competition and pricing pressure; reliance on distributors and channel partners; concentration in a few distributors (Exclusive accounted for 30% of revenue and 38% of net receivables in 2018); product defects or security failures; component shortages and third-party manufacturing exposure; and demand, inventory, foreign-exchange, tariff and macroeconomic uncertainty.
- Legal matters include an ongoing U.S. Attorney’s Office inquiry concerning Trade Agreements Act compliance, with settlement discussions underway, and patent litigation filed by British Telecommunications and Finjan in 2018. Management states it did not believe existing claims were likely to materially affect financial position, but outcomes remain uncertain.
- Other notable items: acquisitions of Bradford Networks and ZoneFox in 2018; the 2017 Tax Act and related tax estimates; $77.5 million of long-term income-tax liabilities for uncertain tax positions; and adoption of the lease accounting standard in 2019, with at least $40 million of lease assets and liabilities estimated for recognition. The auditor issued unqualified opinions on the financial statements and internal controls.
Most important facts for investors to verify
- How much reported earnings growth reflects sustainable operations versus Topic 606 accounting effects and the unusual tax benefit.
- Whether service renewals, deferred revenue and billings continue to grow, and how service and product mix affects margins and cash conversion.
- Exposure to Exclusive and other distributors, including receivable concentration, channel inventory and collection risk.
- Progress and spending on the Sunnyvale campus, share repurchases and acquisitions, and their effect on free cash flow.
- Developments in the government inquiry, patent cases, tax audits and uncertain tax positions, as well as component availability and cybersecurity/product reliability.