Fortinet, Inc. — Q3 2020 Form 10-Q Summary
Reporting period: Quarter and nine months ended September 30, 2020. All financial amounts below are in U.S. dollars; financial statement amounts are in millions unless stated otherwise.
Business context
Fortinet sells cybersecurity products and services, including FortiGate appliances, security subscriptions and technical support, through a global channel-partner model. It reports one operating segment. Services accounted for 66% of Q3 revenue. The company acquired cloud security provider OPAQ Networks in July 2020 to expand its Secure Access Service Edge (SASE) capabilities; the acquisition was not material to the reported financial statements.
Financial performance and liquidity
| Metric | Q3 2020 | Q3 2019 | Nine months 2020 | Nine months 2019 |
|---|---|---|---|---|
| Revenue | $651.1 | $548.1 | $1,846.4 | $1,544.9 |
| Product revenue | $223.8 | $197.1 | $628.0 | $549.7 |
| Service revenue | $427.3 | $351.0 | $1,218.4 | $995.2 |
| Gross profit / gross margin | $511.9 / 78.6% | $424.0 / 77.4% | $1,443.4 / 78.2% | $1,179.5 / 76.3% |
| Operating income / margin | $126.9 / 19% | $100.6 / 18% | $362.4 / 20% | $228.9 / 15% |
| Net income | $123.4 | $80.2 | $341.8 | $213.5 |
| Diluted earnings per share | $0.75 | $0.46 | $2.03 | $1.22 |
- Q3 revenue grew 19% year over year; product revenue grew 14% and service revenue 22%. For the nine-month period, revenue grew 20%, with product revenue up 14% and service revenue up 22%.
- Q3 service growth reflected security subscriptions and technical support. Gross margin improvement was driven mainly by product margins, including lower hardware costs as a share of product revenue. Nine-month service margins also improved.
- Nine-month operating income included a $39.0 million gain related to a patent covenant-not-to-sue agreement. The gain was $1.1 million in Q3. Accordingly, reported nine-month operating income and margin include a material nonrecurring item.
- Net cash provided by operating activities was $220.8 million in Q3, versus $221.2 million a year earlier; reported non-GAAP free cash flow was $185.7 million versus $203.7 million. For the first nine months, operating cash flow was $787.2 million versus $617.6 million and included the $50.0 million cash receipt under the IP agreement.
- At September 30, cash and cash equivalents were $882.3 million and investments were $892.3 million, totaling $1.775 billion, down from $2.210 billion at year-end 2019. Working capital was $739.0 million, compared with $1.313 billion at year-end.
- Current assets were $2.385 billion and current liabilities $1.646 billion. Deferred revenue totaled $2.392 billion, up $282.9 million, or 13%, from year-end. Remaining performance obligations were $2.39 billion; the company expected approximately $1.30 billion to be recognized over the next 12 months.
- The balance sheet presents no separate borrowings line; the filing does not provide a clear total debt figure. Fortinet reported $48.2 million of operating lease liabilities. It also paid $4.1 million of debt assumed in the OPAQ acquisition during the period.
Material changes and unusual items
- Fortinet repurchased 11.4 million shares for $1.05 billion during the first nine months of 2020. The board increased the authorization to $3.0 billion and extended the program through February 28, 2022; $1.05 billion remained available at September 30. No shares were repurchased in Q3.
- The repurchases contributed to the decline in cash and investments and reduced shares outstanding. Nine-month financing cash outflow was $1.120 billion, primarily due to repurchases and taxes paid on net-settled equity awards.
- Interest income fell to $2.5 million in Q3 from $11.4 million, and to $15.7 million for nine months from $32.6 million, reflecting lower rates and lower invested balances.
- Effective tax rates were 4% in Q3 and 8% for nine months, versus 24% and 16%, respectively, in the comparable periods. The 2020 rates benefited from stock-based compensation tax benefits and the foreign-derived intangible income deduction.
- The filing corrected an immaterial revenue-recognition error for certain FortiCare standalone contracts. The error affected prior periods, including 2019 and the first half of 2020; the company stated the correction did not affect billings, operating cash flow or free cash flow.
Outlook, management commentary and risks
- The filing provides no numerical revenue or earnings guidance. Management expected R&D and sales and marketing expenses to increase in absolute dollars during the remainder of 2020; G&A expense was expected to remain flat or increase. Estimated 2020 headquarters construction spending was $95 million to $105 million, with completion expected in the first half of 2021 after COVID-related delays.
- Management said the pandemic’s future effects remained uncertain and could materially harm future results. Reported impacts included reduced travel and event costs, extended payment terms for some distributors, longer sales cycles for some customers, and increased inventory held to mitigate supply risks. The company reported that 94% of outstanding trade receivables was due for collection in Q4 2020.
- Key risks include dependence on distributors, customer and distributor credit exposure, supply-chain and component availability, quarter-end sales concentration, competition and pricing, product vulnerabilities and cybersecurity threats, and the uncertain effects of COVID-19. One distributor represented 29% of Q3 revenue and 31% of net accounts receivable at September 30.
- Fortinet had $284.7 million in potentially noncancelable inventory purchase commitments and $23.1 million in other potentially noncancelable contractual commitments with terms over one year. The company reported ongoing litigation but said it was not aware of claims likely to have a material adverse effect; outcomes remain uncertain.
- Management concluded disclosure controls were effective as of September 30, 2020, and reported no material changes in internal control over financial reporting during the nine-month period.
Important facts for investors to verify
- How much reported operating-income growth depends on the $39.0 million IP gain, and how underlying margins evolve without it.
- Whether billings and deferred-revenue growth continue to support future service revenue, and how service renewals and contract duration develop.
- Collections from distributors, including the impact of extended payment terms and concentration in major distributors.
- Cash and investment levels after substantial repurchases, remaining repurchase activity, and planned headquarters and other capital spending.
- Whether COVID-related sales-cycle delays, supply constraints and inventory increases affect revenue, margins, cash flow or liquidity in subsequent periods.
- The effects of the FortiCare revenue-recognition correction on previously reported periods and the status of related controls and procedures.