Fortinet, Inc. — Q3 2021 Form 10-Q
Business context and reporting period. Fortinet sells cybersecurity products and services, including FortiGate network-security products, security subscriptions and technical support. This unaudited filing covers the three and nine months ended September 30, 2021; comparisons are with the corresponding 2020 periods. Amounts are in U.S. dollars.
Key financial metrics
| Metric | Q3 2021 | Q3 2020 | First nine months 2021 | First nine months 2020 |
|---|---|---|---|---|
| Revenue | $867.2 million | $651.1 million | $2,378.6 million | $1,846.4 million |
| Product revenue | $337.1 million | $223.8 million | $876.1 million | $628.0 million |
| Service revenue | $530.1 million | $427.3 million | $1,502.5 million | $1,218.4 million |
| Gross profit / margin | $656.0 million / 75.6% | $511.9 million / 78.6% | $1,823.9 million / 76.7% | $1,443.4 million / 78.2% |
| Operating income / margin | $166.4 million / 19.2% | $126.9 million / 19.5% | $435.5 million / 18.3% | $362.4 million / 19.6% |
| Net income attributable to Fortinet | $163.1 million | $123.4 million | $407.8 million | $341.8 million |
| Diluted EPS | $0.97 | $0.75 | $2.44 | $2.03 |
| Operating cash flow | $398.8 million | $220.8 million | $1,132.9 million | $787.2 million |
| Free cash flow (non-GAAP) | $329.8 million | $185.7 million | Not stated for the period | Not stated for the period |
Q3 billings, a non-GAAP measure, were $1.064 billion, up 42% year over year. Q3 operating cash flow and free cash flow are the figures presented in management’s key-metrics discussion; free cash flow is defined there as operating cash flow less property and equipment purchases, excluding significant non-recurring items.
Balance sheet, liquidity and debt
- At September 30, 2021, cash and cash equivalents were $1.852 billion; short- and long-term investments were $1.526 billion; and marketable equity securities were $40.8 million. Together these totaled $3.419 billion, versus $1.956 billion at December 31, 2020.
- Working capital was $1.766 billion, compared with $910.9 million at year-end 2020. Current assets were $3.964 billion and current liabilities were $2.198 billion.
- Long-term debt, net of discount and issuance costs, was $988.0 million. Fortinet issued $1.0 billion of senior notes in March: $500 million at 1.0% due 2026 and $500 million at 2.2% due 2031. The notes are unsecured and have no financial covenants. The $17.6 million of AlaxalA-assumed debt outstanding at quarter-end was repaid in October 2021.
- Deferred revenue was $3.106 billion, up 19% from December 31, 2020. Remaining performance obligations were also reported at $3.11 billion; about $1.62 billion was expected to be recognized in the next 12 months.
- Nine-month investing cash outflow was $1.059 billion, including net investment purchases, $160 million invested in Linksys, property and equipment purchases, acquisitions and marketable equity purchases. Financing cash inflow was $716.4 million, principally reflecting the senior-note proceeds, partly offset by repurchases and employee-tax withholding.
Material changes versus the prior comparable periods
- Q3 revenue rose 33% year over year; product revenue increased 51% and service revenue 24%. For the first nine months, revenue grew 29%, with product revenue up 40% and service revenue up 23%.
- Growth was broad geographically. Q3 revenue increased 29% in the Americas, 33% in EMEA and 43% in APAC. Management cited FortiGate demand and growth across Security Fabric products, subscriptions and support.
- Gross margin declined 3.0 percentage points in Q3 and 1.5 points for the nine-month period. Management attributed the declines mainly to a mix shift toward lower-margin products; Q3 product margin was also affected by supply-chain costs, product mix and AlaxalA consolidation, while service margin reflected AlaxalA and data-center expansion.
- Q3 operating income increased 31%; nine-month operating income increased 20%. The year-over-year nine-month comparison includes a much larger prior-year IP-related gain: $39.0 million in 2020 versus $3.4 million in 2021. Excluding that gain, management said nine-month operating margin improved 0.7 percentage points.
- Operating cash flow for the first nine months rose 44% to $1.133 billion, supported in part by a $497.1 million increase in deferred revenue. Cash and investments increased while debt was added through the March note issuance.
Outlook, commentary, risks and unusual items
- Outlook: The filing does not provide a clear revenue or earnings forecast. Management expected research and development, sales and marketing, and general and administrative expenses to increase in absolute dollars during the remainder of 2021. Full-year 2021 capital expenditures were estimated at $315 million to $335 million, with the estimate increased mainly because of real-estate purchases. Management said available cash, cash equivalents and investments, together with operating cash flow, were expected to meet anticipated needs for at least the next 12 months.
- Supply chain and COVID-19: Fortinet reported chip and component shortages, higher component and shipping costs, longer lead times, and insufficient inventory to meet all product demand promptly. It increased inventory and supplier commitments and shifted primarily to air freight. Management cautioned that further disruption could delay billings and product revenue, raise costs and pressure margins; service-revenue effects may follow as contracts are recognized over time.
- Commitments: Non-cancelable inventory purchase commitments were $868.0 million, mostly payable in 2021 and 2022. Other non-cancelable commitments with remaining terms over one year were $68.9 million.
- Litigation: After October 2021 settlement discussions in a patent-infringement lawsuit, the company deemed a loss probable and accrued $5 million in Q3, recorded against revenue. The outcome and settlement terms were not finalized in the filing. Fortinet also stated that IP litigation could entail additional costs, damages or royalties.
- Acquisitions and investments: Fortinet acquired 75% of Japan-based AlaxalA on August 31 for $64.2 million; it contributed $15.6 million of September revenue. The purchase-price allocation remained preliminary. Fortinet invested a further $85 million in Linksys during Q3, bringing its as-converted ownership to 50.8%; it accounted for the investment under the equity method and did not consider itself to have absolute control.
- Capital allocation: Fortinet repurchased $200.4 million of shares in the first nine months. In October, the board authorized an additional $1.25 billion for repurchases and extended the program to February 28, 2023, bringing total authorization to $4.25 billion. The company also bought Texas real estate for $22.5 million in October.
- Revenue concentration: Distributors were significant: Exclusive Networks accounted for 31% of Q3 revenue and 30% of net receivables at quarter-end; Ingram Micro accounted for 12% of Q3 revenue and 11% of net receivables. Six distributors together represented 67% of net receivables.
Most important facts for investors to verify
- Whether supply constraints, product availability and elevated purchase commitments affect subsequent billings, revenue, inventory levels and product margins.
- Whether growth in deferred revenue and billings converts into recognized revenue and cash flow, and whether service renewals remain strong.
- The final settlement outcome and total cost of the patent litigation for which $5 million was accrued.
- AlaxalA’s final purchase accounting, integration progress and contribution to results, as well as Linksys investment performance and accounting.
- Distributor credit exposure and concentration, particularly Exclusive Networks and the six distributors representing most receivables.
- Debt servicing, capital expenditure spending and execution of the expanded share-repurchase authorization against liquidity needs and other investment priorities.