Business context and reporting period
Fortinet, Inc. provides cybersecurity products and recurring subscription and technical-support services. This unaudited Form 10-Q covers the quarter and six months ended June 30, 2017; comparisons are with the corresponding 2016 periods unless stated otherwise. The company reports one operating and reportable segment.
Financial results and liquidity
| Metric | Q2 2017 | Q2 2016 | Six months 2017 | Six months 2016 |
|---|---|---|---|---|
| Revenue | $363.5 million | $311.4 million | $704.0 million | $596.0 million |
| Product revenue | $142.7 million | $136.6 million | $278.0 million | $261.2 million |
| Service revenue | $220.8 million | $174.8 million | $426.1 million | $334.8 million |
| Gross margin | 73.7% | 72.9% | 73.6% | 72.8% |
| Operating income (loss) | $28.5 million | ($4.0 million) | $33.9 million | ($7.7 million) |
| Net income (loss) | $23.0 million | ($1.4 million) | $33.8 million | $0.7 million |
| Diluted EPS | $0.13 | ($0.01) | $0.19 | $0.00 |
- Margins and expenses: Q2 service gross margin rose to 84.2% from 81.9%, while product gross margin fell to 57.4% from 61.4%, primarily due to higher inventory reserves during an appliance transition and other charges. Operating expenses increased 4% in Q2 and 10% for the half, but declined as a share of revenue.
- Cash flow: Six-month operating cash flow was $274.5 million, versus $168.5 million. Investing activities used $113.2 million, including $99.9 million in property and equipment purchases; financing activities used $17.2 million. Cash and cash equivalents increased to $853.1 million from $709.0 million at year-end.
- Liquidity and obligations: Cash, cash equivalents and investments totaled $1.465 billion at June 30, up from $1.311 billion at December 31, 2016; working capital was $719.1 million. Deferred revenue was $1.161 billion, up $126.1 million from year-end. No debt balance is presented on the reported balance sheet. Contractual obligations totaled $177.4 million, including operating leases, inventory commitments and other purchase commitments.
- Q2 non-GAAP indicators: Billings were $426.9 million versus $373.8 million. Free cash flow was $58.4 million versus $53.5 million; Q2 operating cash flow of $144.8 million was offset in part by $86.4 million of property and equipment purchases.
Material changes versus the prior comparable period
- Revenue grew 17% in Q2 and 18% for the first half. Service revenue grew 26% and 27%, respectively, substantially faster than product revenue, which grew 4% and 6%.
- Operating results improved from losses to profits in both comparison periods, supported by higher revenue and lower sales and marketing and general and administrative expense as percentages of revenue.
- Total gross margin expanded by 0.8 percentage points in both Q2 and the first half, primarily due to the higher mix and margin of services.
- Six-month capital expenditures more than doubled year over year, in part due to the $84.8 million Burnaby, Canada real estate purchase. Property and equipment, net, rose to $238.5 million from $137.2 million at year-end.
- Cash from operations increased 63% year over year for the first half. Deferred revenue grew 12% from year-end, reflecting growth in subscription and support contracts.
Outlook, management commentary, risks and unusual items
- Management expected research and development expense as a percentage of revenue to remain relatively comparable for the rest of 2017, and sales and marketing and general and administrative expenses to rise in absolute dollars. It expected second-half capital expenditures to revert to lower levels and free cash flow to increase.
- Management expected 2017 real estate capital expenditures of approximately $120 million, including the Burnaby purchase, and approximately $60 million annually in 2018 and 2019 for the Sunnyvale headquarters build-out; timing remained uncertain. It expected to repurchase at least $150 million of stock in 2017. In July, the board increased the repurchase authorization by $300 million to $600 million and extended the program through January 31, 2019.
- Management said existing cash and cash equivalents would be sufficient for anticipated needs for at least 12 months. However, $671.9 million of cash and investments was held by international subsidiaries and was not immediately available for domestic operations without repatriation, which could trigger U.S. federal income tax.
- Revenue depends heavily on recurring FortiGuard and FortiCare services, renewals, channel partners and distributors. Exclusive Networks accounted for 20% of Q2 revenue; Fine Tec Computers accounted for 12% and Ingram Micro for 10%. Exclusive and Fine Tec together represented 36% of net accounts receivable at quarter-end; Exclusive announced its acquisition of Fine Tec in July.
- The company received an ongoing information request from the U.S. Attorney’s Office concerning Trade Agreements Act compliance and said it was cooperating. It also disclosed U.S. federal and French tax examinations. Management did not believe existing litigation was likely to have a material adverse effect, while noting outcomes were uncertain and IP litigation could affect future margins.
- Adoption of the new revenue standard was planned for January 1, 2018. Fortinet expected the ongoing revenue-recognition pattern to be substantially unchanged, but said capitalizing and amortizing incremental contract-acquisition costs, including sales commissions, was likely to have a material financial-statement impact; its quantitative analysis was ongoing.
- Other principal risks include variable quarterly demand and quarter-end shipment concentration, competition and pricing pressure, inventory obsolescence or shortages, reliance on contract manufacturers and limited component sources, cybersecurity product defects, foreign-exchange exposure, and execution risks involving real estate expansion and business systems.
Important facts for investors to verify
- Whether service growth, renewals and billings continue to support deferred revenue and operating cash flow, and how these trends translate into recognized revenue.
- Whether product gross-margin pressure from inventory reserves and appliance transitions persists or reverses.
- The realized cost and timing of planned real estate spending, and its effect on capital expenditures and free cash flow.
- Developments in the Trade Agreements Act inquiry, tax examinations and other legal matters, including any material financial exposure.
- The quantified effect and implementation readiness for the 2018 revenue standard, particularly capitalization of sales commissions.
- Distributor concentration and receivables exposure following Exclusive Networks’ acquisition of Fine Tec, as well as the effect of the expanded share-repurchase program on liquidity.