Fortinet, Inc. — Q3 2013 Form 10-Q
Business context and reporting period
Unaudited results for the three and nine months ended September 30, 2013, compared with the corresponding 2012 periods. Fortinet sells network security appliances, subscriptions, support, and related services worldwide; FortiGate is its core product family. Revenue is primarily generated through channel partners.
Financial performance
| Metric | Q3 2013 | Q3 2012 | Nine months 2013 | Nine months 2012 |
|---|---|---|---|---|
| Revenue | $154.7m | $136.3m | $437.9m | $382.5m |
| Gross profit / margin | $110.8m / 71.6% | $98.5m / 72.3% | $311.2m / 71.1% | $276.5m / 72.3% |
| Operating income / margin | $18.3m / 12% | $25.8m / 19% | $47.4m | $65.4m |
| Net income | $11.0m | $17.2m | $32.3m | $45.3m |
| Diluted EPS | $0.07 | $0.10 | $0.19 | $0.27 |
| Operating cash flow | $25.4m | $40.8m | $100.7m | $133.6m |
- Q3 revenue grew 14% year over year: product revenue rose 11% to $69.7m and services revenue rose 20% to $83.9m. Nine-month revenue grew 15%, with product revenue up 9% and services up 21%.
- GAAP operating income declined 29% in Q3 and 27% for the nine months; net income fell 36% and 29%, respectively. Operating expenses increased 27% in Q3 and 25% year to date, driven largely by hiring and investment in sales, marketing, and product development.
- Gross margin declined year over year, chiefly reflecting product mix and higher overhead, plus increased technical-support investment and growth in lower-margin consulting services.
- At September 30, cash and cash equivalents were $144.5m; short- and long-term investments totaled $696.5m; cash, cash equivalents, and investments were $841.0m. Working capital was $338.6m. The filing reports no debt balance.
- Deferred revenue was $400.2m, up $37.0m from December 31, 2012. Q3 billings, a company-defined non-GAAP metric, were $165.2m, versus $145.0m.
- Nine-month investing cash outflow was $104.1m, mainly net investment purchases, acquisitions, and capital expenditures. Q3 free cash flow, a non-GAAP measure, was $22.2m versus $24.3m.
Material changes, outlook, and risks
- Management attributed growth to a somewhat better business environment, improved sales execution, and traction in newer products. FortiGate entry-level, wireless/access-point, and high-end enterprise products contributed to growth. Revenue increased across the Americas, EMEA, and APAC; management noted increased macroeconomic pressure in APAC.
- Management expected R&D, sales and marketing, and general and administrative expenses as a percentage of revenue to remain at approximately comparable levels for the remainder of fiscal 2013. It stated existing cash, equivalents, and investments should cover anticipated needs for at least 12 months. No revenue or earnings forecast was provided.
- Headcount rose to 2,238 from 1,854 a year earlier. Stock-based compensation was $11.8m in Q3 and $31.8m for the nine months, a significant recurring expense.
- Fortinet acquired Coyote Point Systems in March and certain Xtera assets in September to expand load-balancing products and technology. It also invested $2.0m in HyTrust and entered a strategic go-to-market alliance.
- The filing identifies risks including unpredictable quarterly results, channel and distributor dependence, inventory and component-supply constraints, competition and pricing pressure, product defects or security failures, international and foreign-exchange exposure, and reliance on subscription/support renewals. Inventory increased to $46.9m from $21.1m at year-end; non-cancelable manufacturer purchase commitments were $46.6m.
- The NPS patent case was abandoned without payment, and NPS and its principals agreed not to sue on related patents. SRI patent litigation remained pending; management said it did not then believe the disclosed litigation would materially harm the business. The filing warns that litigation outcomes are uncertain and may entail costs or royalties.
- A $3.0m non-recurring balance-sheet reclassification related to a 2009 share repurchase was recorded; management considered it immaterial to current and prior periods. The effective tax rate was 40% in Q3 and 36% year to date. Unrecognized tax benefits were $28.7m, with $2.3m accrued interest; the company said it could not estimate timing of future cash outflows for uncertain tax positions.
Most important facts for investors to verify
- Whether services growth and deferred-revenue/billings trends continue, and how renewals affect future recognized revenue.
- Whether expense growth, stock-based compensation, and margin pressure improve relative to revenue growth.
- Inventory levels, supplier lead times, and the $46.6m of potentially non-cancelable manufacturing orders.
- Developments in the SRI litigation, uncertain tax positions, and the California tax audit.
- Performance and integration of acquired technologies, and whether management’s 12-month liquidity assessment remains valid.